Introduction To Macro Economics | Intro To Macroeconomics

Introduction To Macro Economics | Intro To Macroeconomics

Macroeconomics is the branch of economics which deals with economic aggregates. It makes a study of the economic system in general Macro Economics perceives the overall dimensions of economic affairs of a country. It looks at the total size, shape and functioning of the economy as a whole, rather than working of articulation or dimension of the individual parts. To use Marshall's metaphorical language, Macro Economics views the forest as a whole, independently of the individual tress composing it. Macro Economics is, in fact, a study of very large, economy, wide aggregate variables like national income, total savings, total consumption, total investment, money supply, general price level, unemployment, economic growth rate, economic development, etc. In this unit, you will be introduced to the knowledge area of macroeconomics.

Developments of Macro Economics

The Great Depression of the 1930s gave birth to a branch of economics that in 1933 Ragnar Frisch called Macro Economics. The developments in Macro Economics can be studied under

three distinct heads:

Classical Macro Economics

Keynesian Macro Economics

Post-Keynesian Macro Economics

Classical Macro Economics

The classical economists took a simpleview of Macro Economic environment of an economy to champion the cause of laissez faire capitalism guided by free market price mechanism, private property rights and commercial profit motive. There are three pillars of classical Macro Economics

JB Say's Law of Market

Say's law argued that an economy is self-regulating provided that all prices, including wages, are flexible enough to maintain it in equilibrium. In a more simplistic, and somewhat inaccurate form, Say's law states that supply creates its own demand and over-production is impossible. This theory has major implications for how governments respond to periods of high unemployment or widespread underemployment.

Fisher's Quantity Theory of Money

If free market price mechanism has to play its role and responsibility, then price must come to exist so as to reflect the relative position of either scarcity or abundance in the market. Price: itself is measured in terms of money. In fact, price is the value of something expressed in a monetary unit Thus, we may have rupee price or dollar price or yen price, which was stated by Fisher. Starting from his 'equation of exchange, we worked out earlier that the money is an instrumental variable to control prices. In other words, when prices are required to fall during inflation time, the Central Bank must reduce money supply. Thus, the quantity of money matters However, money should always be treated as a servant rather than as a master. The economy needs to keep money stock under control so that the general free level does not get disturbed and price mechanism functions to ensure an optimal allocation of resources. Thus, Fisher's quantity theory of money works as a supplement to Say's law of market. One is not complete without the other.

Keynesian Macro Economics

John Maynard Keynes is well known for his simple explanation for the cause of the Great Depression Keynes economic theory was based on a circular flow of money. His ideas spawned a slew of interventionist economic policies during the Great Depression. In Keynes' theory, one person's spending goes towards another's eamings, and when that person spends her eamings she is in effect, supporting another's eamings. This circle continues on and helps support a normal functioning economy. When the Great Depression hit. people's natural reaction was to hoard their money. Under Keynes theory this stopped the circular flow of money, keeping the economy at a standstill.

Keynes's view that governments should play a major role in economic management marked a break with the laissez-faire economics of Adam Smith, which held that economies function best when markets are left free of state intervention. Keynes argued that full employment could not always be reached by making wages sufficiently low. Economies are made up of aggregate. quantities of output resulting from aggregate streams of expenditure - unemployment is caused if people don't spend enough money. Keynes stated that if Investment exceeds Savings, there will be inflation. If Savings exceeds Investment there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving 

Post Keynesian Macro Economics

Post-Keynesians are highly concerned with short-term economic growth as induced by aggregate demand. For them, the adjustment process of the economy to equilibrium conditions is not so "automatic" as neoclassical economist's claimed because it largely depends on the economic agent's interpretation of both the past and expectations for the future all in the midst of a decision-making setting involving complex interdependencies and unforeseen factors. As a result of these beliefs, post-Keynesians essentially deny relevance of conventional equilibrium analysis. They argue that saving is passively linked to changes in level of income, and investment is highly correlated with capitalists expectations for the future. Another area where post-Keynesians have divergent economic thought from orthodoxy has to do with their belief in the endogeneity of money. For them, post-Keynesians stress the fact that real commodity and labor flows are expressed in the economy as monetary flows.

Importance of Macro Economics

Over the decades that followed up to the present, the interactions of economic events, economic policy, and macro economic theory have created a fascinating story integral to the life and politics of national economies around the world. The following statements assert the importance of macro economies

It explains the working of the economic system as a whole. It examines the aggregate behaviour of Macro Economies entities like firms households and the govemment. Its knowledge is indispensable for the policy-makers for formulating macro-economic policies such as monetary policy, fiscal policy, industrial policy, exchange rate policy, income policy, etc. It is very useful to the planner for preparing economic plans for the country's development It is helpful in intemational comparison.

Scope of Macro Economics

Macro Economics is the study of the aggregate modes of the economy, with specific focus on problems associated with those modes the problems of growth, business cycles, unemployment and inflation. The Macro Economic theory is designed to explain how supply and demand in the aggregate interact to concern with these problems:

Economic growth takes place when both the total output and total income are increasing. GNP is the basic measure of economic activity Gross National Product (GNP) is the value of all final goods and services produced in the e economy in a given time period. Nominal GNP measures the value of output at the prices prevailing in the period, during which the output is produced, while Real GNP measures the P measures the output produced in any one period at the prices of some base year.

Inflation rate is the percentage rate of increase of the level of prices during a given period.

Unemployment rate is the fraction of the labour force that cannot find jobs.

Business cycle is the upward or downward movement of economic activity that occurs around th trend. The top of a cycle is called the peak. A very high peak, representing a big jump the growth in output, is called a 'boom'. When the economy starts to fall from that peak, there is a downturn in business activity. If that downturn persists for more than two consecutive quarters year, that downturn becomes a recession. A large recession is called a depression. In general, latter is much longer and more severe than a recession. The bottom of a recession or depression is called the trough. When the economy comes out of the trough, economists say it is an upturn. If an upturn lasts two consecutive quarters of the year, it is called an expansion.

The output gap measures the gap between actual output and the output the economy could produce at full employment given the existing resources. Full employment output is also called Potential output. Okun's rule of thumb determines the relation between the unemployment rate and income. It

states that a 1 per cent change in the unemployment rate will cause income in the economy to change in the opposite direction by 2.5 per cent.

The Phillips curve suggests a tradeoff between inflation and unemployment. Less unemployment can always be obtained by incurring more inflation inflation can be reduced by allowing more unemployment However, the short and long run tradeoffs between inflation and unemployment are a major concern of p cern of policy making

The basic tools for analyzing output, price level, inflation and growth are the aggregate supply and demand curves. Aggregate demand is the relationship between spending on goods and services and the level of prices. The aggregate supply curve specifies the relationship between the amount of output firms produce and the price level. Shifts in either aggregate supply or aggregate demand will cause the level of output to change-thus affecting growth and will also change the price level - thus affecting inflation

Objectives of Macro Economic policies

Objectives refer to the aims or goals of government policy whereas instruments are the means by which these aims might be achieved and targets are often thought to be intermediate aims linked closely in a theoretical way to the final policy objective. If the government might want to achieve low inflation, the main instrument to achieve this might be the use of interest rates and a target might be the growth of consumer credit or perhaps the exchange rate.

Broadly, the objective of Macro Economic policies is to maximise the level of national income, providing economic growth to put on a pedestal the utility and standard of living of participants in the economy. There are also a few secondary objectives which are held to lead to the maximisation of income over the long run. While there are variation between the objectives of

different national and interational entities, most follow the ones detailed below:

Sustainability: A rate of growth which allows an increase in living standards without undue structural and environmental difficulties Full Employment: Where those who are competent and willing to have a job can get hold of one, given that there will be a certain amount of frictional and structural unemployment

Price Stability: When prices remain largely stable, and near is not rapid inflation or deflation.

Price stability is not necessarily the same as zero inflation, but instead steady level of low

moderate inflation is often regarded as ideal. It is worth note that prices of some goods and services often fall as a result of productivity improvements during period of inflation, as inflation is only a measure of general price level.

External Balance: Equilibrium in the balance of payments, lacking the use of artificial

constraints. That is, exports roughly equal to imports over the long run.

Equitable distribution of Income and Wealth A fair share of the national 'cake', more equitable

than would be within the case of an entirely free market.

Increased Productivity: more output per unit of work per hour. Only a limited number of policies can be used achieve the govemment's objectives. There is a huge amount of research conducted in trying to determine the effectiveness of different policies. in meeting key objectives. Indeed the debates about which policies are most suitable lie at the heart of differences between economic schools of thought.

The main instruments available to meet the objectives are: Monetary Policy: changes to interest rates, the supply of money and credit and changes to the exchange rate

Fiscal Policy: changes to government taxation, government spending and borrowing. Supply-side Policies: designed to make markets work more efficiently. Direct controls or regulation of particular markets.

Instruments of Macro Economic Policy

The main instruments of Macro Economic policy are:

Monetary Policy

Monetary policy is one of the tools that a national govemment uses to influence its economy Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is Macro Economic stability-low unemployment, low inflation, economic growth, and a balance of external payments.

Fiscal Policy

Fiscal policy is an additional method to determine public revenue and public expenditure. In the recent years importance of fiscal policy has increased due to economic fluctuations. Fiscal policy is an important instrument in the modern time. According to Arther Simithies fiscal policy is a policy under which government uses its expenditure and revenue programme to produce desirable effects and avoid undesirable effects on the national income, production and employment.

Supply Side Policies

Supply side economics is the branch of economics that considers how to improve the productive capacity of the economy. It tends to be associated with Monetarist, free market economics. These economists tend to emphasise the benefits of making markets, such as labour markets more flexible. However, some supply side policies can involve government intervention to overcome market failure. Supply Side Policies are government attempts to increase productivity and shift Aggregate Supply (AS) to the right. Benefits of supply side policies are:

Lower Inflation

Lower Inflation: Shifting AS to the right will cause a lower price level By making the economy more efficient supply side policies will help reduce cost push inflation.

Lower Unemployment

Lower Unemployment: Supply side policies can help reduce structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment.

Improved Economic Growth

Improved Economic Growth Supply side policies will increase the sustainable rate of economic growth by increasing AS.

Improved Trade and Balance of Payments

Improved Trade and Balance of Payments: By making firms more productive and competitive they will be able to export more. This is important in light of the increased competition from China and Oriental nations.

Direct Control

The government affects business transactions and activities of an economy through a system of controls and regulations Fiscal and monetary policies constitute 'indirect' or 'general controls, they affect the overall aggregate demand of the economy. In contrast, there may be direct or physical controls, they affect particular choices of consumers and producers. Such controls are in the form of licensing, price controls, rationing, quality control, monopoly control, regulation of restrictive trade practices, export incentives, import duties, import-export and exchange regulations, quotas, authorization and agreements, anti-hoarding and anti-smuggling schemes, etc. It is this complex and varied set of direct controls, which is often, referred to the term Physical Policies. Unlike fiscal and monetary policies, which affect the entire economy, physical policies tend to affect the strategic point of the economy, they are specially oriented and discriminatory in nature. They are designed and executed to overcome specific shortages and surpluses in the economy. Thus, the basic purpose of physical policies is to ensure proper allocation of scarce resources like food, raw materials, consumer goods, capital equipment, basic facilities, foreign exchange, etc.