Introduction to Macroeconomics

Branches of Economics

Economics

MacroeconomicsMicroeconomics

Branches of Economics

• 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 is macroeconomics?

• First look at :• Output and its rate of growth• Inflation rate • Unemployment rate• International trade

Measuring Economic growth

• Gross Domestic Product (GDP)Value of all the final goods and services produced

within a country in given period of time.• Real GDPThe volume of goods and services produced within a

country (i.e. GDP adjusted for inflation) • Economic growthPercentage rate of increase of real GDP

Measuring Inflation

• Inflation is an increase in the overall price level.• Percentage change in the price level• GDP Deflator• Consumer price index (CPI)

Measuring Unemployment

• Labor force = employed + unemployed• Unemployment rate = unemployment/labor force• Unemployment= Does not have a job and has been

seeking for a job for past 4 weeks.• The long term unemployment is the share of

unemployed persons since 12 months and more in the total numbers of the active persons in labor market.

International trade/ Trade balance

• The balance between imports and exports.• Balance of trade = exports are equal to

imports.

Three Models

• Macroeconomics is organised around three models

• Each model is concerned with different time frames– The long run– The medium run– The short run

• Let’s consider each in more detail

Very Long Run Economic Growth

• Growth theory describes the long run behaviour of the economy

• The time is usually measured in multiples of decades (e.g. 20 years or more)

• The focus is on the average growth in important macroeconomic variables

• Short-run fluctuations in important variables like employment, investment and output are ignored

Very Long Run Economic Growth

• The long run level of output is determined solely by supply-side considerations

• That is, output is determined by the productive capacity of the economy

• All factors of production are assumed to be fully employed

• Economic growth is, therefore, a function of increases in productive capacity

Very Long Run Economic Growth

• Differences in average growth rates of economies are important

• Major causes of economic growth are– Development of new technology– Accumulation of physical and human capital– Appropriate provision of infrastructure– Higher rates of domestic saving

Very Long Run Economic Growth

• Economic growth determines the changes in the standard of living

• A country growing at an average of 4% per year instead of 2% will have a 50% higher standard of living over a generation of 20 years

• This higher 4% average annual growth rate will lead to a seven fold increase in the standard of living over 100 years!

• Let’s now introduce a model which will be useful for our analysis

Fixed Productive Capacity

• What determines the change in the overall price level (the inflation rate)?

• The aggregate supply (AS)–aggregate demand (AD) model explains short- to medium-run determination of inflation and real output

• In the long run the productive capacity of the economy is assumed to be constant

Fixed Productive Capacity

• This is represented by a vertical AS schedule at real output level Y0

P

Y0 Y

AS

Pri

ce L

evel

Fixed Productive Capacity

• The AD schedule represents, for each price level, the level of output where both the goods and money markets are in equilibrium

• These schedules will be fully explained in next lectures

• The intersection of the AS and AD schedules determines the price (P0) and real output (Y0)

Fixed Productive Capacity

• AD and AS in the long run

P

Y0 Y

AD

Pri

ce L

evel

AS

P0 What happens when AS shifts rightwards?

What happens when AD shifts rightwards?

Price increases

Price decreases

The Short Run

• Short-run fluctuations in real output are important

• AD is the major determinant of these variations

• In the short run the price level is pegged at P0 making the short-run AS schedule horizontal

AS

The Short Run

• AD and AS in the short run

P

Y0 Y

AD

Pri

ce L

evel

P0

What happens when AD shifts rightwards?

Price unchanged

The Medium Run

• How do we describe the transition between the short run and long run?

• High AD pushes real output above Y0 (according to the long-run model)

• Over time, firms will increase prices and the AS curve will move upwards

• The medium run will give an upsloping AS curve

The Medium Run

• The relative steepness of the AS curve is a major controversy in macroeconomics

P

Y0 Y

AD

Pri

ce L

evel

AS

P0

To Reiterate …

• Growth theory, AS and AD form a very important framework for the further analysis of– Growth and GDP– The business cycle

• Let’s consider each in turn

Growth and GDP

The Business Cycle and GDP

• The business cycle describes the variation of economic activity around the path of trend growth

• Inflation, growth and unemployment all demonstrate cyclical patterns

• The output gap measures the difference between actual and potential output:

Output gap = potential output – actual output

• Potential Output:Total gross domestic product (GDP) that could be

produced by an economy if all its resources were fully employed.

• Actual OutputActual output is the "real" GDP ( gross domestic product).

The Business Cycle and Inflation

• Increases in inflation are inversely related to the output gap

• Expansionary AD policies tend to produce inflation when unemployment is relatively low

• The cost of the cycle above trend is inflation and the cost below trend is unemployment

Business Cycle Features

• Business cycles have common characteristics• Procyclical variables rise with expansionary

business activity (e.g. output, employment, interest rates and money supply)

• Countercyclical variables (like inventories and bankruptcies) move in the opposite direction to business activity

• Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations.

• An economic policy that is believed to decrease fluctuations is called countercyclical.

Business Cycle Features

• Some variables exhibit more variability than others (e.g. inventories are volatile while consumption is smooth, especially relative to output)

• The impulse-propagation model describes:– how a shock (impulse) disturbs the economy

from a long-run trend– which lasts (propagates) over time

• Economists disagree over possible propagation mechanisms

Business Cycle Features

• There are three broad types of shocks– Policy shocks which affect fiscal expenditure

and interest rates (e.g. fiscal and monetary policies)

– Supply shocks which affect production and price-setting (e.g. technology advances)

– Private sector shocks which affect aggregate demand (e.g. changes in private investment)

Business Cycle Features

• There is debate about the actual timing of business cycles

• Which measure should be used?– Variables like unemployment lag changes in real

GDP (called lagging indicators)– Leading indicators like firms’ profitability and

building approvals precede changes in GDP– Aggregating variables into a composite index will

give a coincident index to measure turning points in the business cycle

Business Cycle Features

• Another debate concerns separating the cycle from trend– The classical business cycle considers actual

levels so that a fall in GDP describes negative growth

– Two consecutive quarters of negative growth in real GDP is called a (classical) recession

– The growth cycle considers fluctuations in growth rates of the economy around the trend growth rate

1.3 Schools of Thought

• During the 1960s there were two main views– The monetarists believed the economy is

best left to itself– The Keynesian’s argued that government

intervention could improve economic performance

• Two schools have developed since then– the new classical school in the 1970s– the Keynesian school in the 1980–90s

New Classical School

• Consistent with the monetarist view– Economic agents optimise– Decisions rationally use all available

information (rational expectations)– Markets are assumed to clear

• These assumptions ensure there is no involuntary unemployment

• The real business cycle extension argues that real supply side shocks are the major causes of fluctuations in economic activity

New Keynesian School

• Extends the earlier Keynesian view that markets will not always clear even if agents are maximising

• Reasons are varied and include– There is incomplete information– Institutions affect the workings of markets– Costs of changing wages and prices lead to

price rigidities• These reasons explain fluctuations in output

and employment

Economic Controversies

• The two main competing views of modern macroeconomics are highlighted in real-world political and media discussions

• Frequently these differences are exaggerated in debate

• There are significant areas of agreement• Debate and research continually evolve new

areas of consensus e.g. there is increasing agreement on information problems with wage-price setting

Thanks