Chapter 1

Introduction to Macroeconomics

BEEB2023 Macroeconomics

University Utara Malaysia

Introduction to Macroeconomics

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

• Macroeconomics deals with the economy as a whole; it examines the behavior of economic aggregates such as aggregate income, consumption, investment, and the overall level of prices.

– Aggregate behavior refers to the behavior of all households and firms together.

What Macroeconomics is About

• Macroeconomics is the study of the structure and performance of national economies and of the policies that governments use to try to affect economic performance.

The Roots of Macroeconomics (1)

• The Great Depression was a period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.

The Roots of Macroeconomics (2)

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

• However, simple classical models failed to explain the prolonged existence of high unemployment during the Great Depression. This provided the impetus for the development of macroeconomics.

The Roots of Macroeconomics (3)

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

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

• During periods of low private demand, the government can stimulate aggregate demand to lift the economy out of recession.

Macroeconomic Concerns

• Three of the major concerns of macroeconomics are:– Inflation– Unemployment– Output growth

1: Inflation and Deflation

• Inflation is an increase in the overall price level.• Hyperinflation is a period of very rapid

increases in the overall price level. Hyperinflations are rare, but have been 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 damaging for the economy as sustained inflation.

Inflation

• When prices of most goods and services are rising over time it is inflation. When they are falling it is deflation.

• The inflation rate is the percentage increase in the average level of prices.

The inflation rate

• Definition: rate at which the price level increases

• Measured– By GDP deflator = nominal GDP / real GDP– By CPI or Consumer Price Index

GDP deflator can be calculated by methods similar to those developed for the calculation of real GDP

Calculation of GDP deflator

That is: the rate of inflation is 18%

CPI or Consumer Price Index

• Based on cost in $ of a fixed basket of goods and services consumed by an average urban consumer

Effects of Inflation• When the inflation rate reaches an

extremely high level the economy tends to function poorly. The purchasing power of money erodes quickly, which forces people to spend their money as soon as they receive it.

2: Output Growth:Short Run and Long Run (1)

• The business cycle is the cycle of short-term ups and downs in the economy.

• The main measure of how an economy is doing is aggregate output:– Aggregate output is the total quantity of

goods and services produced in an economy in a given period.

Expansion and Contraction:The Business Cycle

• An expansion, or boom, is the period in the business cycle from a trough up to a peak, during which output and employment rise.

• A contraction, recession, or slump is the period in the business cycle from a peak down to a trough, during which output and employment fall.

Output Growth:Short Run and Long Run (2)

• A recession is a period during which aggregate output declines. Two consecutive quarters of decrease in output signal a recession.

• A prolonged and deep recession becomes a depression.

• Policy makers attempt not only to smooth fluctuations in output during a business cycle but also to increase the growth rate of output in the long-run.

3: Unemployment

• The unemployment rate is the percentage of the labor force that is unemployed.

• The unemployment rate is a key indicator of the economy’s health.

• The existence of unemployment seems to imply that the aggregate labor market is not in equilibrium. Why do labor markets not clear when other markets do?

Unemployment rate u

• L = N + U– L is labor force– N is number of employed– U is number of unemployed

• u = U/L– u is rate of unemployment

• Data gathered by Department of Statistics

• Current Population Survey

Government in the Macroeconomics

• There are three kinds of policy that the government has used to influence the macroeconomic:1. Fiscal policy

2. Monetary policy

3. Growth or supply-side policies

Government in the Macroeconomy

• Fiscal policy refers to government policies concerning taxes and spending.

• Monetary policy consists of tools used by the Federal Reserve to control the quantity of money in the economy.

• Growth policies are government policies that focus on stimulating aggregate supply instead of aggregate demand.

The Three Market Arenas (1)

• Households, firms, the government, and the rest of the world all interact in three different market arenas:1. Goods-and-services market [IS]

2. Labor market [AS] [AD]

3. Money (financial) market [LM]

The Three Market Arenas (2)

• Households and the government purchase goods and services (demand) from firms in the goods-and services market, and firms supply to the goods and services market.

• In the labor market, firms and government purchase (demand) labor from households (supply).

– The total supply of labor in the economy depends on the sum of decisions made by households.

The Three Market Arenas (3)

• In the money market—sometimes called the financial market—households purchase stocks and bonds from firms.– Households supply funds to this market in the expectation of

earning income, and also demand (borrow) funds from this market.

– Firms, government, and the rest of the world also engage in borrowing and lending, coordinated by financial institutions.

Issues Addressed by Macroeconomists

• What determines a nation’s long-run economic growth?

• What causes a nation’s economic activity to fluctuate?

• What causes unemployment?

Issues Addressed by Macroeconomists (continued)

• What causes prices to rise?

• How does being a part of a global economic system affect nations’ economies?

• Can government policies be used to improve economic performance?

Long-Run Economic Growth

– Rich nations have experienced extended periods of rapid economic growth.

– Poor nations either have never experienced them or economic growth was offset by economic decline.

Increased Output

• Total output is increasing because of increasing population, i.e. the number of available workers.

• Increasing average labour productivity: the amount of output produced per unit of labour input.

Rates of Growth of Output• Rates of growth of output (or output per

worker) are determined by:– rates of saving and investment;– rates of technological change;– rates of change in other factors.

Business Cycles

• Business cycles are short-run contractions and expansions of economic activity.

• The most volatile period in the history of Canadian output was between 1914 and 1945.

Recessions• Recession is the downward phase of a

business cycle when national output is falling or growing slowly.– Hard times for many people– A major political concern

Unemployment

• Recessions are usually accompanied by high unemployment: the number of people who are available for work and are actively seeking it but cannot find jobs.

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The International Economy• An economy which has extensive trading

and financial relationships with other national economies is an open economy. An economy with no relationships is a closed economy.

Exports and Imports• Canadian exports are goods and services

produced in Canada and consumed abroad.

• Canadian imports are goods and services produced abroad and consumed in Canada.

Trade Imbalances

• Trade imbalances (trade surplus and deficit) affect output and employment.– Trade surplus: exports exceed imports.– Trade deficit: imports exceed exports.

The Exchange Rate• The trade balance is affected by the

exchange rate: the amount of Malaysia Ringgit that can be purchased with a unit of foreign currency.

Macroeconomic Policy

• A nation’s economic performance depends on:– natural and human resources;– capital stock;– technology– economic choices made by citizens;– macroeconomic policies of the government.

Macroeconomic Policy (continued)

• Macroeconomic policies:– Fiscal policy: government spending and

taxation at different government levels.– Monetary policy: the central bank’s control of

short-term interest rates and the money supply.

Budget Deficits• The economy is affected when there are

large budget deficits: the excess of government spending over tax collection.

Budget Deficits (continued)

• The large budget deficits of the 1980s and early 1990s are unusual.– Borrowing from the public might divert

funds from more productive uses.– Federal budget deficits might be linked to

the decline in productivity growth.

Aggregation• Macroeconomists ignore distinctions

between individual product markets and focus on national totals.

• The process of summing individual economic variables to obtain economywide totals is called aggregation.

What Macroeconomists Do• Macroeconomic forecasting

• Macroeconomic analysis

• Macroeconomic research

• Data development

Macroeconomic Forecasting

• Macroeconomic forecasting – prediction of future economic trends - has some success in the short run. In the long run too many factors are highly uncertain.

Macroeconomic Analysis• Macroeconomic analysis - analyzing and

interpreting events as they happen – helps both private sector and public policymaking.

Macroeconomic Research• Macroeconomic research - trying to

understand the structure of the economy in general – forms the basis for macroeconomic analysis and forecasting.

Economic Theory

• Economic theory: a set of ideas about the economy to be organized in a logical framework.

• Economic model: a simplified description of some aspects of the economy.

Developing and Testing a Theory

• State the research question.• Make provisional assumptions.• Work out the implications of the theory.• Conduct an empirical analysis.• Evaluate the results.

Data Development

• Macroeconomists use data to assess the state of the economy, make forecasts, analyze policy alternatives, and test theories.

Data Development (continued)

• Providers of data must: – Decide what types of data should be collected

based on who is expected to use the data and how.

– Ensure the measures of economic activity correspond to economic concepts.

– Guarantee the confidentiality of data.

Why Macroeconomists Disagree

• A positive analysis examines the economic consequences of an economic policy, but it does not address its desirability.

• A normative analysis tries to determine whether a certain economic policy should be used.

Why Macroeconomists Disagree (continued)

• Economists can disagree on normative issues because of differences in values.

• Economists disagree on positive issues because of different schools of thought.

The Classical Approach

• The invisible hand of Economics: General welfare will be maximized (not the distribution of wealth) if:– there are free markets;– individuals act in their own best interest.

The Classical Approach (continued)

• To maintain markets’ equilibrium – the quantities demanded and supplied are equal:– Markets must function without impediments.– Wages and prices should be flexible.

The Classical Approach (continued)

• Thus, according to the classical approach, the government should have a limited role in the economy.

The Keynesian Approach

• Keynes (1936) assumed that wages and prices adjust slowly.

• Thus, markets could be out of equilibrium for long periods of time and unemployment can persist.

The Keynesian Approach (continued)

• Therefore, according to the Keynesian approach, governments can take actions to alleviate unemployment.

The Keynesian Approach (continued)

• The government can purchase goods and services, thus increasing the demand for output and reducing unemployment.

• Newly generated incomes would be spent and would raise employment even further.

Evolution of the Classical-Keynesian Debate

• After stagflation – high unemployment and high inflation – of the 1970s, a modernized classical approach reappeared.

• Substantial communication and cross-pollination is taking place between the classical and the Keynesian approaches.

Unified Approach to Macroeconomics

• Individuals, firms and the government interact in goods, asset and labour markets.

• The macroeconomic analysis is based on the analysis of individual behaviour.

The Unified Approach (continued)

• Keynesian and classical economists agree that in the long run prices and wages adjust to equilibrium levels.

• The basic model will be used either with classical or Keynesian assumptions about flexibility of wages and prices in the short run.