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INTRODUCTION TO MACROECONOMICS

Notes and Summary of Readings

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Topics Covered
What macroeconomics is about What macroeconomists do Why macroeconomists disagree

Definition of macroeconomics

Macroeconomic forecasting

Positive analysis and normative analysis

Difference between micro and macroeconomics

Data collection and analysis

The classical approach

Basic issues in macroeconomics

Macroeconomic research

The Keynesian approach

References

Macroeconomics by Abel, Bernanke and Croushore Chapter 1* (main reference) Macroeconomics by Dornbusch and Fischer Chapter 1* (for supplementary reading)

* These chapters are available online for free reading.

What Macroeconomics is about


Let us start by reading about some news topics that generated debate and discussion in the world of economics... 1) FDI in multi-brand retail (India, Sep 2012) 2) Debt crisis (Eurozone) 3) Fiscal cliff (USA, Dec 2012 / Jan 2013) 4) Direct cash transfer program (India, Jan 2013) 5) Record high unemployment rate (Eurozone, Jan 2013)

While reading the above articles, you would have come across terms like growth, unemployment, inflation, depression, debt, deficit, interest rate, savings, exchange rate, economic policy etc. The branch of economics that deals with all these issues, and much more, is called macroeconomics. Formally, macroeconomics is defined as the field concerned with the structure and performance of national economies and the policies governments use to try to affect economic performance.
Structure refers to the relationship between input-output accounts, levels of consumption and investment, sectors of the economy, relationships between different sectors, degree of independence of the economy etc.

Difference between microeconomics and macroeconomics The difference between the two fields is primarily one of approach and emphasis. Diff. in approach:
Microeconomics Macroeconomics
Focuses on the choices made by the individual decision-making units of the society-typically the consumers and firms- and the impact of those choices on individual markets Concerns itself with choices made by the macro players of the economy- such as the government, the central bank etc. and the impact of those choices on the economy as a whole

Bottoms-up approach

Top-down approach

Diff. in emphasis
Macroeconomics Emphasizes on aggregate quantities such as aggregate consumption, aggregate investment and aggregate output; fine distinctions among different kinds of goods, firms and markets are usually ignored

Microeconomics Studies the demand and supply in individual markets, each of which is too small to have an impact on the national economy

Phenomena affecting the Phenomena such as inflation and economy as a whole, like inflation unemployment are among the or unemployment, are either not key variables studied mentioned or are taken as given, as these are not variables that individual buyers or sellers can change

Some basic issues in Macroeconomics


What determines a nations long-run economic growth? What causes a nations economic activity to fluctuate?

What causes unemployment?

What causes prices to rise? How is a nations economy affected by being part of the international economy? Can (and should) the government do anything to improve economic performance?

Long-run economic growth Economic growth is the increase in the amount of the goods and services produced by an economy over time. i.e. the quantitative changes taking place in an economy. Economic growth is measured in terms of real Gross National Product (GNP) or Gross Domestic Product (GDP). It is different from economic development because the latter also takes into account qualitative changes taking place in the economy, such as improvement in socio-cultural relations, health care, literacy etc. Rich nations: Experienced periods of rapid economic growth at some point in their history. Developing nations: Never experienced sustained
1.

Factors important for long-term economic growth:


Availability of resources: Exploitation of natural resources, increase in workforce & capital stock contribute to greater output

Efficiency of labour force: Education, training & experience increase average labour productivity**
Efficiency of capital: Improvement in knowledge & technological change increase productivity of land, machines & buildings Rates of investment and saving in the economy

** Output per unit of employed labour

2. Business cycles As said earlier, an increase in the availability of resources and improvements in efficiency help a country to register an upward trend in long-run economic growth. But it has been observed that at any given point of time, the rate of economic growth is greater than, smaller than, or sometimes equal to, the general trend. For example, the trend in the USA over the last century has been one of rising economic growth. However, the growth hasnt been smooth and has numerous hills and valleys. During the 1960s, national output nearly doubled, but during 1973-75, 1981-82, and 1990-91, output declined from one year to the next.

These short-run fluctuations, called business cycles, exist not only for economic growth, but also for other macroeconomic variables such as inflation and unemployment. Formally, a business cycle is defined as the more or less regular pattern of expansion and contraction in economic activity around the path of trend growth. It is important to note that business cycles do not include fluctuations that last only for a few months, such as the spurts in economic activity that occur around major festivals.
In the past few years, we often came across the term recession in newspaper articles. Recession simply refers to the downward phase of a business cycle, during which national output may be falling or

3. Unemployment Unemployment (joblessness) occurs when people are without work and actively seeking work. The prevalence of unemployment in an economy is measured by the unemployment rate, which is calculated as a percentage by dividing the number of unemployed individuals by all individuals currently in the labour force. An economy usually experiences a relatively high unemployment rate during periods of recession. But even if the economy on the whole is doing very well, the unemployment rate can remain fairly high.
Example: 1933 USA: Great Depression era. Unemployment rate 24.9% 1944 USA: Peak of war time boom. National output doubles. Unemployment rate significantly small, 1.2% 2000 USA: 4% even after prolonged economic growth with no

4. Inflation When the prices of most goods and services are rising over time, the economy is said to be experiencing inflation. The percentage increase in the average level of prices over a year is called the inflation rate. If the inflation rate in consumer prices is 10%, then on an average the prices of items that consumers buy are rising by 10% per year. In contrast, deflation is the fall in the average level of prices. The last major deflation in the USA was seen during the Great Depression. After that, rising prices have been the normal state of affairs. High inflation is a major issue because it greatly reduces the purchasing power of consumers. When inflation rates are extremely high, the economy tends to function poorly. A deflation too, is nothing to be excited about, as falling prices reduce the incentive of producers to sell goods.

5. The international economy Today, every major economy is an open economy, which means that it has extensive trading and financial relationships with other national economies. (This is in contrast to a closed economy, which doesnt interact economically with the rest of the world.) A macroeconomist studying the international economy would be interested in knowing how economic links among nations, such as international trade and borrowing, affect the performance of individual economies and the world economy as a whole.

Some major issues related to the international economy are: 1) How are business cycles transmitted from one country to another? 2) Why do trade imbalances take place? Are they good or bad for the economy? Exports are goods and services produced within the nation and sold to other countries. Imports are goods and services produced abroad and purchased by people within the country. An excess of exports over imports is called trade surplus, while an excess of imports over exports is called trade deficit. 3) How does the foreign exchange rate (value of one countrys currency in terms of another currency) affect international trade? 4) How do immigration and outsourcing affect an economy? Related articles: Immigration in Canada,

6) Macroeconomic policy An extremely important factor affecting economic performance is the set of macroeconomic policies pursued by the government. The two major types of policies are: Fiscal policy concerns government spending and taxation determined at the national, state and local levels Monetary policy determines the rate of growth of money supply in the country under the control of the central bank

What are federal budget surpluses and deficits? Do governments usually run a surplus or a deficit?

Which is the central bank in India? In the USA?

What macroeconomists do
Teach economics at the college or school level Engage in macroeconomic forecasting

Work as analysts in govt/pvt organizations


Enter the research arena in macroeconomics Collect data related to macroeconomic variables

Macroeconomic forecasting An economist trying to forecast (predict) the performance of the economy will be concerned with questions such as: How will a severe drought in agricultural regions affect food quantities and prices? Will productivity rise as rapidly in the future as it did during the tech boom of the early 2000s? How will a crisis in the middle east affect fuel prices? Owing to the complexity of the economic system, answering such questions with a high degree of accuracy is close to impossible. So, a macroeconomic forecaster will usually talk in terms of most likely forecasts, while offering optimistic and pessimistic alternative scenarios. In this sense, he/she is very similar to a meteorologist both can only talk about the probability of an event taking place.

Macroeconomic analysis Macroeconomic analysts monitor the economy and think about the implications of current economic events. In private sector organizations (like banks and large corporations), the job of an analyst is to try to determine how general economic trends will affect their employers financial investments, their opportunities for expansion, the demand for their products, and so on. In public sector agencies (such as the government, the World Bank and the International Monetary Fund) the main function of analysts is to assist in policymaking. The ultimate decisions regarding economic policy are taken by politicians, who may or may not heed the advice of macroeconomists in

Macroeconomic research The role of a macroeconomist engaged in research is to make general statements about how the economy works. Research can take a variety of forms, from abstract mathematical analyses to psychological experimentation to simulation experiments representing the randomness of day-to-day economic activity. Like many other fields, macroeconomic research proceeds primarily through the formulation and testing of theories. An economic theory is a set of ideas about the economy organized in a logical framework. Most economic theories are developed in terms of an economic model, which is a simplified description of some aspect of the economy, usually expressed in mathematical form. A useful economic theory has the following characteristics: 1. It is based on reasonable and realistic assumptions

Data development Several macroeconomists are involved in the process of collecting data on macroeconomic variables such as the price level, measures of output etc. This economic data is used to assess the current state of the economy, make forecasts, analyze policy alternatives, and test macroeconomic theories. In the USA, most economic data is collected by agencies such as the Bureau of the Census, the Bureau of Labour Statistics, and the Bureau of Economic Analysis.

Why macroeconomists disagree


A positive analysis of an economic policy examines the economic consequences of a policy but doesnt address the question of whether those consequences are desirable. A normative analysis of an economic policy tries to examine the desirability of an economic policy

Disagreements between macroeconomists may arise due to differences in normative conclusions, and because of differences in the positive analysis of a policy proposal. There have always been many schools of thought in macroeconomics, but the most important and enduring disagreements on positive issues involve the two schools of thought called the classical approach and the Keynesian approach.

The classical approach Origin: Can be traced back to as early as 1776, when Scottish economist Adam Smith published The Wealth of Nations. Main idea: Free markets are guided by the invisible hand, which operates through the price mechanism. Economic agents-typically firms and households-look at the prices in the market, and use the available information to make rational decisions that maximize their selfinterest in the given circumstances. If they could increase their welfare by adjusting their wages or prices, there is no reason why they would not do so. As a result, wages and prices in an economy adjust reasonably quickly to equate supply and demand in all markets. A major implication of these assumptions is that there is no possibility for involuntary unemployment in the economy. Proponents of the classical approach believe that the invisible hand works well to ensure the economic welfare of the whole society, so that there is only a limited scope for government intervention. Well-known classicals: Robert Lucas, Thomas Sargent, Robert Barro, Edward Prescott and Neil Wallace, all of whom were influenced by the ideas of Adam Smith and Milton Friedman.

The Keynesian approach Origin: Relatively recent, during the Great Depression of the 1930s. Introduced by John Maynard Keynes in his book General Theory of Employment, Interest, and Money (1936) Main idea: The unprecedentedly high rates of unemployment of the 1930s could not be explained by the classical theory. The thoery appeared to be inconsistent with the data collected from the real world, and the invisible hand seemed completely ineffective. This led Keynes to suggest an alternative explanation for unemployment: There are problems of asymmetric information, and high costs related to frequent price changes, due to which prices and wages do not adjust rapidly enough to maintain market equilibrium at all times. Slow price and wage adjustment means that the supply of labour may exceed the demand for long periods of time-leading to high and persistent unemployment. Proponents of this approach tend to be sceptical about the invisible hand and thus are more willing to advocate a role for government in improving macroeconomic performance. Influential Keynesians: Franco Modigliani and James Tobin were among the early Keynesians. The new generation of Keynesians includes George Akerlof, Janet Yellen, David Romer, Olivier Blanchard, Gregory Mankiw, Larry Summers and Ben Bernanke.

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