MACROECONOMICS I

(ECON 311)
OUTLINE
1. INTRODUCTION

2. NATIONAL INCOME ACCOUNTING

3. AGGREGATE DEMAND

4. AGGREGATE SUPPLY

5. OPEN ECONOMY MACROECONOMICS

6. BEHAVIORAL CONSUMPTION
 CHAPTER ONE
INTRODUCTION
1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.1 Classical and Neo-classical
Macroeconomics
1.2.2 Keynesian Macroeconomics
1.2.3 Monetarists
1.2.4 New Classicals
1.2.5 New Keynesians
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
 Macroeconomics: is the study of the behavior
of the economy as a whole & the policy
measures that the government uses to
influence it.
 It is concerned with:
 The economy’s total output of goods &
services and the growth of output,
 Booms & recessions,
 The rates of inflation and unemployment,
 Balance of payments & exchange rates.
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
 Central issues (focus areas) in macroeconomics:
 economic growth,
 inflation,
 unemployment, and
 open economy market policies
 Major policy instruments in macro-economics:
 fiscal,
 monetary, and
 trade policy instruments.
 Income policy
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
 In macroeconomics, we do two things:
1. we seek to understand the economic
functioning of the world we live in; and
2. 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.
 Macroeconomics makes use of:
 algebraic & geometric tools of analysis like
differentiation & graphs;
 models like AD-AS model & IS-LM model.
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
Two Basic Questions & Two Broad Answers in
Macroeconomics
1) Can Governments influence the Economy?
No Yes
Classicals & Neoclassicals Keynesians
New Classicals (?) Monetarists (?)
New Keynesians
2) Should Governments Intervene?
No Yes
Classicals & Neoclassicals Keynesians
Monetarists
New Classicals (?) New Keynesians
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1.2 The State of Macroeconomics: Evolution & Recent
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.1 Classical & Neo-classical Macroeconomics
Basic Assumptions:
Flexible wages and prices.
Supply creates its own demand, Say’s Law.
Forward-looking agents with perfect foresight.
The price level is proportional to the money
stock in the long run.
Main argument:
No need for government intervention as the
economy has a self-correction mechanism.
Inflation is caused by excessive growth in money
stock.
 No distinction b/n macro- & micro-economics.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.2 Keynesian Macroeconomics
 The birth of modern macroeconomics is linked to
the Great Depression (period of high unemp’t &
stagnant production) & Keynes.
 The market adjustment concept of classicals &
neoclassicals didn’t work during 1929-1933.
 Basic Assumptions:
 Economy is unstable due to shifts in AD.
 Nominal wages & prices are inflexible, esp.
downwards.
 Large multiplier effect for changes in
government spending & tax rates.
 Keynes emphasized “effective demand” or AD,
and proposed expansionary policies.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
These Policies are fiscal & monetary:
1. Increasing government expenditure (G):
G  AD  Y (production).
Y (output/income)  C (Consumption) 
AD  Y ... – the multiplier effect.
2. Increasing money supply (M):
M  r (interest rate)  I (investment) 
AD  Y ... – the multiplier effect.
But, all the M may be absorbed at the existing
r (esp. when recession is deep) – the economy is
in liquidity trap!
With liquidity trap, the Classical model is
incapable of producing equilibrium – Keynes.
 Keynes preferred fiscal to monetary policy.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Keynes focused primarily on short-term: cure for
immediate problem almost regardless of long-
term results of the cure.
 But, AD:
(given supply) may  inflation, and
may  long-term growth rate (by ring
saving/investment if firms/people decide not to
accumulate wealth in fear of future increase in
taxes). With lower long-term growth rate, the
economy would create fewer jobs & thus
unemp’t rate would rise.
 For Keynesians, inflation can be controlled with
contractionary fiscal or monetary policy.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.3 Monetarists
 Strongly debated against the Keynesians on:
 the ability of government to improve the
operation of the economy;
 the relative importance of fiscal & monetary
policy;
 the tradeoff between inflation & unemp’t (the
Phillips Curve) – problem of stagflation (=
stagnation + inflation).
 Expansionary fiscal policy, with monetary
authority raising M growth, leads to inflation.
 Fiscal policy affects the mix b/n private &
government use of resources – insignificant or no
multiplier effect in fiscal policy.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Monetary policy is very powerful & changes in M
explain most fluctuations in output.
The Great Depression resulted from major
mistake in monetary policy.
 The tradeoff b/n unemp’t & inflation quickly
vanishes if policy makers try to exploit it: no long-
run tradeoff b/n inflation & unemp’t.
 Because of uncertainty in the position of the
economy & lags in policy effects, policy measures
may do more harm than good.
 Though an economy can be unstable in the short-
run, it has a good self-correcting mechanism in
the long run.
 Inflation is chiefly a monetary phenomenon.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.4 New Classicals
 In the 1970s, the debate on active policy brought
to the fore new groups – new classicals & new
Keynesians.
 New classicals attached great importance to the
role of expectation in influencing macro-
economic equilibrium.
 They introduced macroeconomic analysis from
micro foundations.
 Expansionary fiscal policy tends to increase
inflationary expectations, shifting AS, causing
real GDP to fall & the price level to rise.
 Many of them supported supply-side policies
meant to raise growth rate of potential GDP.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Their central working assumptions are:
 forward looking economic agents with rational
expectations.
 Markets clear.
 AS is responsive to changes in expectations
about inflation.
 Incentives to produce, work & save are
affected by government policies which
influence marginal tax rates and subsidize
households and businesses.
 The self-correction mechanism is based on shifts
in AS caused by changes in expectations of
inflation.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.5 New Keynesians
 They gave micro foundation for Keynesian
thoughts.
 Markets sometimes do not clear even when
individuals are rationally looking out for their
own interests.
 Emphasize imperfections in various markets
(labor, credit, product).
 Information problems & costs of changing prices
may lead to price rigidities, causing
macroeconomic fluctuations in output & emp’t.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
Conclusion:
 Much is to be learned from the insights of all
these schools of macroeconomics, and each has
contributed to our understanding of the way the
economy works.
 However, there is no single school that best
describes how an economy operates.
 The majority of economists now agree that:
 Stabilization policies are likely to influence
incentives of households & firms,
 Long-term growth (in real GDP), resulting from
capital accumulation & technological progress, is
the key to raise living standards.
 Changes in AD affect output (at least) in the
short run.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Some of the disagreements involve:
 The length of the “short run,” the period of time
over which AD affects output.
 The role of policy. Those who believe that output
returns quickly to the natural level advocate the
use of tight rules on both fiscal & monetary
policy. Those who believe that the adjustment is
slow prefer more flexible stabilization policies.
THE END OF CHAPTER ONE!!!

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