1 Macro Introduction

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Prof Arjun MadanProf Arjun Madan Lecture Slides on Macro Economics IndicatorsLecture Slides on Macro Economics Indicators

Introduction to

Macroeconomics


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© 2004 Prof Arjun Madan© 2004 Prof Arjun Madan Lecture Slides on Macro Economics IndicatorsLecture Slides on Macro Economics Indicators 2 of 35

Introduction to Macroeconomics

• Microeconomics examines the behavior of individualdecision-making units—business firms and households.

• Macroeconomics deals with the economy as a whole; it

examines the behavior of economic aggregates suchas aggregate income, consumption, investment, and theoverall level of prices.

• Aggregate behavior refers to the behavior of all

households and firms together.


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• Microeconomists generally conclude that markets workwell . Macroeconomists, however, observe that someimportant prices often seem “sticky.”

• Sticky prices are prices that do not always adjustrapidly to maintain the equality between quantitysupplied and quantity demanded.


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• “Macroeconomics is the study of the behaviour ofthe economy as a whole. It examines the overalllevel of a nation’s output, employment, prices, and

foreign trade.”P. A. Samuelson


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The Roots of Macroeconomics

• The Great Depression was a period ofsevere economic contraction and highunemployment that began in 1929 andcontinued throughout the 1930s.


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• In 1936, John Maynard Keynes published The GeneralTheory of Employment, Interest, and Money .

• Keynes believed governments could intervene in theeconomy and affect the level of output and employment.

• During periods of low private demand, the governmentcan stimulate aggregate demand to lift the economy

out of recession.


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GENESIS OF MACRECONOMICS :

1) Although macroeconomic elements can be traced backto the periods of Mercantilism and Physiocracy, the

analytical elements of macroeconomics started only with

the classical economists.

2) The expression macroeconomics was used by Frisch in

1933.


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• Classical economists applied microeconomic models, or“ market clearing” models, to economy-wide problems.

• However, simple classical models failed to explain theprolonged existence of high unemployment during theGreat Depression. This provided the impetus for thedevelopment of macroeconomics.


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GENESIS OF MACRECONOMICS – ( CONT.)

• A systematic attempt to study macroeconomics started

with the publication of Keynes’s General Theory of

Employment, Interest and Money in (1936).

Although most of his teachers in Cambridge were the

classical economists, Keynes fundamentally differed with

their understanding, analysis and policy implications.

• Let’s see some of the basic differences between the

Classical economists and Keynes on many

macroeconomic issues.


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4. Differences between the Classicalsand Keynes

Classical Views

1. There is a directrelationship between themoney supply and theprice level

2. Saving – investment

equality is brought aboutby the rate of interestmechanism

Keynesian Views

1. No such directrelationship exists. Therelation is only indirect.

2. The equality betweensaving and investment is

brought about by theincome level.


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Differences between the Classicalsand Keynes – cont.

3. Rate of interest is a flow.

4. Labour supply dependson the real wage rate.

5. The economy is at fullemployment equilibrium

3. Rate of interest is a stock.

4. Supply of labour dependson the money wage rate.

5. The economy is atunderemploymentequilibrium.


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6. The automaticadjustments works.

7. No speculative demandfor money.

8.Wages are flexible.

9. Supply creates its owndemand.

6. There is no such thing.

7. There is speculativedemand for money.

8. Wages are rigiddownward.

9. Supply is generallygreater than demand(they are not equal)


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10.Rate of interest is areward for saving.

11. Laissez Faire

12. When the wage levelgoes down, employmentgoes up.

10. Rate of interest is areward for parting withliquidity.

11. No Laissez Faire.

12. When wage level goesdown, employment goes

down.


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Differences between the Classicalsand Keynes (contd.)

13. Saving is good.

14. Balanced Budget

15. Long Run

13. Saving is bad.

14. Unbalanced Budget.

15. Short Run


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Recent Macroeconomic History

• Fine-tuning was the phrase used by Walter Heller torefer to the government’s role in regulating inflation andunemployment.

• The use of Keynesian policy to fine-tune the economy inthe 1960s, led to disillusionment in the 1970s and early1980s.


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Recent Macroeconomic History

• Stagflation occurs when the overall price levelrises rapidly (inflation) during periods of

recession or high and persistent unemployment(stagnation).


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Inflation and Deflation

• Hyperinflation is a period of very rapid increases in theoverall price level. Hyperinflations are rare, but havebeen used to study the costs and consequences of

even moderate inflation.• Deflation is a decrease in the overall price level.

Prolonged periods of deflation can be just as damagingfor the economy as sustained inflation.


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Recession and Depression

• A recession is a period during which aggregate outputdeclines. Two consecutive quarters of decrease inoutput signal a recession.

• A prolonged and deep recession becomes adepression .

• Policy makers attempt not only to smooth fluctuations in

output during a business cycle but also to increase thegrowth rate of output in the long-run.


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© 2004 Prof Arjun Madan© 2004 Prof Arjun Madan Lecture Slides on Macro Economics IndicatorsLecture Slides on Macro Economics Indicators

Macroeconomics as a TheoreticalScience

• Explains the behaviour of macroeconomic variables and

specifies the nature of relationship between them;

• Provides an insight into, the working of the economy ;

and

• Is a necessary condition for the formulation of appropriate

macroeconomic policies to achieve predetermined goals.


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Macroeconomics as a Policy Science

• Provides a sound theoretical framework for investigatingthe causes and effects of economic problems;

• Provides guidelines for finding appropriate policymeasures to solve the problem , and

• Analyses the working and effectiveness of macroeconomic policies, especially the monetary andfiscal policies, on the economy.


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Origin and Growth of Macro Economics

• The Classical Macro Economics

• The Keynesian Revolution

• The Post-Keynesian Developments


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The Classical Macroeconomics

• According to classical school of thought, if market forces of demand and supply are allowed to work freely, then

i. there will always be full employment in the long

run , and unemployment, if any, will be a short-runphenomenon;

ii. there will be neither over-production nor under-production at the aggregate level; and

iii. the economy will always be in equilibrium in thelong run.


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The Keynesian Revolution

• The level of output and employment in an economy isdetermined by the aggregate demand given theresources.

• The unemployment in any country is caused by lack of aggregate demand and economic fluctuations arecaused by demand deficiency.

• The demand deficiency can be removed throughcompensatory government spending .


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Post-Keynesian Developments inMacroeconomics

• Monetarism: A Counter Revolution,

• Neo-classical macroeconomics,

• Supply-side economics, and

• Neo-Keynesianism.


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Monetarism

• According to the Monetarists, the role of money is

central to the growth and the stability of national output

• Money supply is the main determinant of output andemployment in the short run and price level in the long

run


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Neo-classical Macroeconomics

• The neo-classical school emphasizes the role of

individual’s rational expectations about future economic

events, especially those taking place on the supply side of

the economy and expectations about future government

policies.


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Supply-side Economics

• Supply-side Economics is led by Arthur Laffer.

• Emphasis is on the role of factors operating the supply

side of market.

• Laffer Curve: a cut in the tax rate shifts aggregate supply

curve rightward and leads to a rise in output and

employment


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Macroeconomic Issues

1. Achieving and maintaining a high rate of economicgrowth,

2. Preventing business cycles when symptoms come up,

3. Controlling inflation and stabilising price level,

4. Solving the problems of unemployment and poverty,

5. Containing growing budgetary defici ts , and

6. Managing international economic issues .


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Growth Related Issues

• In Developed countries:

i. How to combat the recessionary trend in the economy,and

ii. How to accelerate the growth rate.

• In Developing countries:

i. How to maintain the current high growth rate;

ii. How to prevent the overheating of the economy; and

iii. How to keep inflation under control within its tolerableand desirable limits.


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The Rate of Economic Growth

• Measured by growth in the Gross Domestic Product or“GDP.”

• GDP is defined as the market value of all the final goodsand services produced in a country in a given year.

• Economists have two ways of measuring GDP, the “flow-of-cost” or “income” approach and the “flow of product”

or “expenditures” approach.

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The Rate of Economic Growth

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Flow of product, orexpenditures, approach

• Consumption expenditures byhouseholds

• plus• Investment expenditures by

businesses

• plus

• Government purchases of

goods and services• plus

• Net exports=total exports-totalimports

=GDP=GDP

Flow of cost, orincome, approach

• Wages

• plus

• Rents

• plus

• Interest

• plus• Profits


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Nominal vs. Real GDP

• Nominal GDP is measured in actual market prices.

• Real GDP is nominal GDP adjusted for inflation.

• Moreover, when we divide nominal GDP by real GDP,we obtain the GDP deflator-another valuable inflationindex.

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Output Growth

• GDP is the best widely available measure of the leveland growth of output in the economy.

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Actual vs. Potential GDP

• Actual GDP represents what we are producing.

• Potential GDP represents the maximum amount theeconomy can produce without causing inflation.

• When actual GDP is less than potential GDP, we are inthe recessionary range of the economy.

• When actual GDP is above potential GDP, we run thestrong risk of inflation.

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The Issue of Business Cycles

• Business cycle refers to high magnitude of fluctuation in

the economy—high growth in GDP/GNP in one period

followed by a sharp decline in the next period.


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Business Cycles

• Closely related to the issue of economic growth and realGDP as a measure of such growth is the problem of“business cycles.”

• The term business cycle refers to the recurrent ups anddowns in real GDP over several years.

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Business Cycles

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TimeTime

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Do Business Cycles Exist

• A central concern of macroeconomists is to determinewhether a business cycle exists and, if so, what are theforces behind it.

• More importantly, both macroeconomists and thepolitical leaders they may serve, want to know whatmacroeconomic policies may be used to control orharness the business cycle.

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At The Same Time

• A central concern of business is to determine whether

the economy is going into a contraction or expansion--

with a correct guess being the difference between a big

profit or a big loss.

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The Issue of Inflation

• Inflation is defined as persistent and considerable

increase in the price level over a long period of time.

• Inflation is generally associated with, and is often causedby, the high growth rate itself.


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Inflation

• Defined as an upward movement of prices from one yearto the next.

• Measured by the percentage change in price indicessuch as the Consumer Price Index, the Producer PriceIndex, or the so-called GDP deflator.

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Some Inflation Indices

• The Producer Price Index is based on a number ofimportant raw materials.

• The Consumer Price Index or “CPI” is calculated bypricing a basket of goods and services purchased by atypical household.

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© 2004 Prof Arjun Madan© 2004 Prof Arjun Madan Lecture Slides on Macro Economics IndicatorsLecture Slides on Macro Economics Indicators 43 of 3543 of 35

Housing32%

Transportation19%

Food17%

Clothing5%

Miscellaneous5%

Health6%

Entertainment5%

Insurance and pensions9%

Education1%

Personal care1%


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The Issue of Unemployment andPoverty

• Unemployment refers to that part of the labour force, orworkforce, which is willing to work at the prevailing wagerate and is looking for a job but is not getting employment.

• Unemployment and poverty have been a perennial problemin both DCs and LDCs.

• Unemployment % change on year ago

India 9.9 (2012)

China 4.1Japan 3.9

US 7.4

Mexico 4.9

Greece 27.6


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Unemployment

• The unemployment rate is measured as the number of

unemployed persons divided by the number of people in

the labor force.

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Kinds of Unemployment

• In talking about unemployment, economists distinguish

between three kinds: frictional, cyclical, and

structural.

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Frictional Unemployment

• Frictional unemployment is the least of themacroeconomist’s worries.

• It occurs as a natural part of the job-seeking process aspeople quit their jobs just long enough to look for andfind another one.

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Cyclical Unemployment

• Cyclical unemployment is a much more serious problem.

• It occurs when the economy dips into a recession.

• It is this type of unemployment that macroeconomistshave historically spent most of their time trying to solve .

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Structural Unemployment

• Structural unemployment occurs when a change in

technology makes someone’s job or job skills obsolete.

• E.g., the auto worker replaced by a robot or thetelephone information operator replaced by a

computerized voice synthesizer.

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The Issue of Budgetary Deficits

• The government budget refers to the annual revenueand expenditure of the government of a country.

• To control and regulate the economy -fiscal policy .

• Budget Balance as % of GDP

India -5.1

US -4.0

China -2.1Canada -2.8

Pakistan -8.8

Mexico -1.8


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The International Economic Issues

• Growing balance of payments deficits,

• Exchange rate fluctuation, and

• Excessive inflow or outflow of capital.

Country Current A/c balance in$bn

% of GDP(2013)

India -87.8 -4.5

China + 211.6 +2.1US -425.7 -2.7

Saudi Arabia + 151.4 +16.0


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Stock and Flow Variables

• Stock Variables -The stock variables refer to the quantityor value of certain economic variables given at a point intime , e.g., stock of capital or Business Inventories on 31stMarch 2006 or Money supply on 31st December 2007.

• Flow Variables - The flow variables are the variables thatare expressed per unit of t ime , e.g., salary per hour,Savings per week, Consumption per month, or GDP peryear.


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Equilibrium and Disequilibrium

• Equilibrium - In economic sense, equilibrium refers to astate or situation in which opposite economic forces, e.g.,demand and supply , are in balance and there is no in-built tendency to deviate from this position.

• Disequilibrium - This is the state in which the oppositeforces (e.g., demand and supply) are in imbalance . The

factors causing disequilibrium arise out of the workingprocess of the economy.


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Partial Equilibrium Analysis

• Partial equilibrium analysis is the analysis of a part of the

economy , isolated and insulated through assumptions

from the influence of changes in the rest of the economy.

• Partial equilibrium analysis is based on ceteris paribus

assumption.


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General Equilibrium Analysis

• General equilibrium analysis is carried out where theobjective is to analyse the economic system as a wholewithout using the restrictive assumptions of the partial

equilibrium analysis.

• It takes a comprehensive and realistic view of the

economic system.


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Static and Comparative Statics Analysis

• Static analysis - When an economy is studied under static

conditions , it is called static analysis. The variables used

in this kind of analysis have no past or future and all

variables belong to the same point in time .

• Comparative statics analysis- Comparative statics is a

comparative study of economic conditions at two staticequilibrium positions at two different points in time.


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Dynamic Analysis

• When a macroeconomic phenomenon is analysed underchanging or dynamic conditions, it is called dynamicanalysis.

• Economic dynamics studies the ‘factors and forces’ that setan economy in motion and lead it to a new equilibrium at ahigher or lower level.

• It takes into account the time lag involved in the process ofadjustments.


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Macroeconomic Model Building

• A macroeconomic model is the representation of the

economic phenomenon in terms of a set of behavioural

assumptions, definitions, simultaneous equations, and

identities.

• Eg: Keynesian Model of Income determination

AD = C + I + G + X


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Government in the Macroeconomy

• There are three kinds of policy that thegovernment has used to influence themacroeconomy:

1. Fiscal policy

2. Monetary policy

3. Growth or supply-side policies


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Government in the Macroeconomy

• Fiscal policy refers to government policies concerningtaxes and spending.

• Monetary policy consists of tools used by the Federal

Reserve to control the quantity of money in theeconomy.

• Growth policies are government policies that focus on

stimulating aggregate supply instead of aggregatedemand.


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Economic Indicators

• Relation to the Business Cycle / Economy

• Procyclic: A procyclic economic indicator is one that

moves in the same direction as the economy. So if the

economy is doing well, this number is usually increasing,

whereas if we're in a recession this indicator is decreasing.

GDP is an example.

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Economic Indicators

• Countercyclic: A countercyclic economic indicator is one

that moves in the opposite direction as the economy. The

unemployment rate gets larger as the economy gets worse.

• Acyclic: An acyclic economic indicator is one that has norelation to the health of the economy and is generally of

little use. The number of runs made by Sachin Tendulkar

has no relationship to the health of the economy.

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Economic Indicators

• Leading: Leading economic indicators are indicators

which change before the economy changes.

• Stock market returns are a leading indicator.

• Leading economic indicators are the most important type

for investors as they help predict what the economy will

be like in the future.

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Economic Indicators

• Lagged: A lagged economic indicator is one that does not

change direction until a few quarters after the economy

does. The unemployment rate is a lagged economic

indicator as unemployment tends to increase for 2 or 3quarters after the economy starts to improve.

• Coincident: A coincident economic indicator is one that

simply moves at the same time the economy does. The

Gross Domestic Product is a coincident indicator.

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Some Important Economic Indicators

• Total Output, Income, and Spending

• Employment, Unemployment, and Wages

• Production and Business Activity

• Prices

• Money, Credit, and Security Markets

• Federal Finance

• International Statistics

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The Methodology of Macroeconomics

• Connections to microeconomics:

• Macroeconomic behavior is the sum of all the

microeconomic decisions made by individualhouseholds and firms. We cannot understand the

former without some knowledge of the factors that

influence the latter.


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Aggregate Supply and Aggregate Demand

• Aggregate demand is thetotal demand for goods andservices in an economy.

• Aggregate supply is thetotal supply of goods andservices in an economy.

• Aggregate supply anddemand curves are morecomplex than simplemarket supply and demandcurves.

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1 Macro Introduction