MEE - 1 - INTRO(2014)

MACROECONOMIC ENVIRONMENT

1. INTRODUCTION

What Is Macroeconomics?• Macroeconomics is the study of the behavior of the economy

as a whole and the policy measures that the government uses to influence it.– Utilizes measures including total output, rates of

unemployment and inflation, and exchange rates.

• Examines the economy in the short run, long run,& very LR.– Short run: movements in the business cycle.– Long run: movement in prices.– Very long run: economic growth.

• Macroeconomics aggregates the individual markets whereas microeconomics examines the behavior of individual economic units and the determination of prices in individual markets.

What Is 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.

• We wonder why some countries are growing faster than others and why inflation fluctuates. Why recessions occur; why economies boom?

• Macroeconomics deals with the performance, structure, behaviour and decision-making of the entire economy.

• Study of macroeconomics is important because the state of the entire economy (macroeconomy) affects everyone in many ways. It plays a significant role in the political sphere while also affecting public policy and societal well-being.

What Is Macroeconomics?What Is Macroeconomics?

• Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions.

• Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, and international trade.

• Macroeconomists are also concerned with issues such as recessions (periods in which real GDP falls mildly) and depressions (when GDP falls more severely), and with monetary and fiscal policies.

What Is Macroeconomics?What Is Macroeconomics?

Some Key Macroeconomic Questions…

• Will tomorrow’s world be more prosperous than today?

• Will jobs be plentiful?

• Will the cost of living be stable?

• Will the government go into deficit again?

Origins and Issues of Macroeconomics

• Economists began to study economic growth, inflation, and international payments during the 1750s.

• Modern macroeconomics dates from the Great Depression, a decade (1929-1939) of high unemployment and stagnant production throughout the world economy.

• The Great Depression was a period of severe economic contraction (falling output, falling investment, falling prices, stock market crash) and high unemployment that began in 1929 and continued throughout the 1930s.

The Roots of Macroeconomics

• 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 modern macroeconomics.

The Roots of Macroeconomics

• 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.

Recent Macroeconomic History

• Fine-tuning was the phrase used to refer to the government’s role in regulating inflation and unemployment.

• The use of Keynesian policy (of demand side management) to fine-tune the economy till the 1960s, led to disillusionment in the 1970s and early 1980s.

• During 1970s and 1980s, economists were more worried about slowing growth and inflation.

Recent Macroeconomic History

• Stagflation occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation).

• Classical macroeconomics (of supply side management) re-emerged to correct stagflation in US and Europe (Barro, Sargent).

The Methodology of Macroeconomics

• Connections to microeconomics:

– Macroeconomic behavior is the sum of all the microeconomic decisions made by individual households and firms. We cannot understand the former without some knowledge of the factors that influence the latter.

Aggregate Supply andAggregate Demand

• Aggregate demand is the total demand for goods and services in an economy.

• Aggregate supply is the total supply of goods and services in an economy.

• Aggregate supply and demand curves are more complex than simple market supply and demand curves of microeconomics.

Aggregate Supply andAggregate Demand

• Aggregate demand (AD) equals total spending on goods and services. It depends on the level of prices, on monetary & fiscal policy & on other factors like wars etc. AD=C+I+G+NX.

• Aggregate supply (AS) depends upon level of prices & costs; & productive capacity (or potential output) of economy, which depends on availability of capital, labour & technology.

While macroeconomics is a broad field of study, there are three areas of research that are typical of the discipline:

• the attempt to understand the causes and consequences of short run fluctuations in national income (the business cycle), and

• the causes & consequences of price fluctuations (in the long run), and

• the attempt to understand the determinants of very long run economic growth (increases in national income).


Macroeconomics In Three Models• Study of macroeconomics is grounded in three models, each

appropriate for a particular time period.

1. Very Long Run Model: domain of growth theory - focuses on growth of the production capacity of the economy.

2. Long Run Model: a snapshot of the very long run model, in which capital and technology are largely fixed.

• The given level of capital and technology determine the level of potential output.

• Output is fixed at potential output, but prices determined by changes in AD.

3. Short Run Model: business cycle theories -• Changes in AD determine how much of the productive

capacity is used and the level of output and unemployment.• Prices are fixed in this period, but output is variable.

AS Curve In The SR, LR & VLR

SR AS

LRAS

VLR AS

Output

PriceLevel

Ypot

AD

Short-Term Versus Long-Term Versus Very Long Term Goals

• The The Very Long RunVery Long Run behaviour of the economy focuses behaviour of the economy focuses on growth theory – i.e it deals with the growth of the on growth theory – i.e it deals with the growth of the economy’s capacity to produce goods & services – economy’s capacity to produce goods & services – through accumulation of capital and improvements in through accumulation of capital and improvements in technology ( Solow, Romer ) – involves a few decades.technology ( Solow, Romer ) – involves a few decades.

• In the In the Long RunLong Run, we assume productive capacity of the , we assume productive capacity of the economy (i.e supply of goods & services) to be fixed. economy (i.e supply of goods & services) to be fixed. Prices and inflation, which are determined by fluctuations Prices and inflation, which are determined by fluctuations in demand, are the subject of study over this time in demand, are the subject of study over this time horizon ( Classical theory ) – involves a decade.horizon ( Classical theory ) – involves a decade.



Short-Term Versus Long-Term Versus Very Long Term Goals

• In the Short Run behaviour of the economy, fluctuations in demand determine how much of the available capacity is used and thus the level of output and unemployment. In the SR, prices are relatively fixed and output is variable. Keynes focused on the short-term—on unemployment and lost production and business cycles – involves period of a few months to a few years.

• Output and prices are determined by aggregate supply and aggregate demand. In the SR, the AS curve is flat. In the LR, the AS curve is vertical.

• Changes in AD, which is on account of changes in fiscal and monetary policy as well as individual decisions about consumption and investment, change output in the SR and change prices in the LR.

• “In the long run,” said Keynes, “we’re all dead.” (Mankiw, Tobin).

• During the 1970s and 1980s, macroeconomists became more concerned about the long-term and very long term macroeconomics - inflation and economic growth.

• The 2007-2009 financial crisis has brought back attention to Keynesian economics alongwith his fiscal policy and monetary policy prescriptions.


Key Macro Concepts

• Economic Growth and Fluctuations

• Inflation

• Jobs and Unemployment

• Surpluses and Deficits

• Macroeconomic Policy Challenges & Tools

Economic Growth and Fluctuations

• Economic growth is the expansion of the economy’s production possibilities.

• We measure economic growth by the increase in aggregate output. Aggregate output is the total quantity of goods and services produced in an economy in a given period. The main measure of how an economy is doing is aggregate output.

• Real GDP—real gross domestic product—is a good measure of aggregate output. It is the value of the total production of all the nation’s farms, factories, shops, and offices, measured in the prices of a single year (produced over the period of one year).

• Potential GDP is the value of real GDP when all the economy’s labour, capital, land, and entrepreneurial ability are fully employed – trend rate of growth.

• Potential GDP shows productive capacity of a nation.


• Real GDP fluctuates around potential GDP in a business cycle–a periodic but irregular up-and-down

movement in production.

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


Economic Growth and FluctuationsShort Run Business Cycle

• 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.

• An expansion is a period during which real GDP increases.

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

The Business Cycle and the Output Gap

• Business cycle is the pattern of expansion and contraction in economic activity about the path of trend growth in the SR.– Trend path of GDP is the path GDP would take if

factors of production were fully utilized-potential output.• Deviation of output from the trend is referred to as the

output gap.– Output gap = actual output – potential output.– Output gap measures the magnitude of cyclical

deviations of output from the potential level.

Economic Growth and FluctuationsShort Run Business Cycle

Every business cycle has two phases:

1. A recession

2. An expansion

And two turning points:

1. A peak

2. A trough

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.

Economic survey 2013-14

Eco survey, 2013-14 : key indicators

Economic Growth and FluctuationsTrend Potential And Actual Output - USA

• This figure shows the most recent U.S. cycles.

Real GDP

Potential GDP

Peak

Peak

Trough

Expansion Expansion

Recession

2010

Forecast of potential growth is between 7 and 7.5% over 2012-14. Source : Ministry Of Finance, 2013

Potential Output, April, 2014, RBI

GDP Growth Over The Years (in %)

FY 2011 = 8.9%

FY 2012 = 6.7%

FY 2013 = 4.5%

FY 2014 = 4.7%

FY 2015 = 5.65%*

*Estimated GDP growth rate for FY15 bet. 5.4-5.9 averaged at 5.65.

source : Economic Survey, 2014-15.

• The main benefit of long-term economic growth is expanded consumption possibilities, including more health care for the poor and elderly, more research on cancer and AIDS, more space exploration, better roads, more and better housing, and a cleaner environment.

• The costs of economic growth are forgone consumption in the present, and more rapid depletion of nonrenewable natural resources.

Benefits and Costs of Economic Growth

Introduction to Key Macro Concepts


• Inflation




Inflation and Deflation

• Inflation is an increase in the overall price level.

• 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• Inflation is a process of rising prices.

• We measure the inflation rate as the percentage change in the average level of prices or the price level.

• The Consumer Price Index — CPI — is a common measure of the price level used to calculate inflation.

• An alternative measure of inflation, called Wholesale Price Index – WPI, is used primarily in India.

Inflation

Is Inflation a Problem?

• Unpredictable changes in the inflation rate are a problem because they redistribute income in arbitrary ways between employers and workers and between borrowers (gain) and lenders (lose).

• Eradicating is costly because it brings a period of greater than average unemployment.

Inflation Rates, India

Inflation Rates, India

source : RBI, M&MD, April, 2014



• Inflation




Unemployment

• The unemployment rate is the percentage of the labor force that is unemployed and looking for a job.

• 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?

Jobs and Unemployment

• Why Is Unemployment a Problem?

• Unemployment is a serious economic, social, and personal problem for two main reasons:– Lost production and incomes– Lost human capital

• The loss of a job brings an immediate loss of income and production—a temporary problem.

• A prolonged spell of unemployment can bring permanent damage through the loss of human capital.

Unemployment Data, India

Source: RBI First Qtr Review, 2011-12

CDS unemployment rate was 5.6% in 2011-12 (68 th round of NSSO).




• Inflation



Surpluses and Deficits

Domestic/Government Budget Surplus and Deficit

• If a government collects more in taxes than it spends, it has a government budget surplus.

• If a government spends more than it collects in taxes, it has a government budget deficit.

Surpluses and Deficits International Surplus and Deficit

• If a nation imports more than it exports, it has an international (trade) deficit.

• If a nation exports more than it imports, it has an international (trade) surplus.

• The current account deficit or surplus is the balance of exports minus imports plus net interest paid to and received from the rest of the world.

• Deficits are a problem since it is a liability for governments and makes them dependent on lenders, domestic or international.

source : Economic survey, 2013-14




• Inflation



Macroeconomic Policy Challenges

Five widely agreed policy challenges for macroeconomics are to:

1. Boost economic growth

2. Keep inflation low

3. Stabilize the business cycle

4. Reduce unemployment

5. Reduce government deficits

Macroeconomic Policy Tools Government in the Macroeconomy

• There are three kinds of policy that the government has used to influence the macroeconomy:

– Fiscal policy– Monetary policy– Growth or supply-side policies

Macroeconomic Policy Tools Government in the Macroeconomy

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

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

• FP & MP affect AD of economy.

• Growth policies are government policies that focus on stimulating aggregate supply instead of aggregate demand. Such policies affect AS of economy.

Why Macroeconomics?

Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy.

Date post:	25-Dec-2015
Category:	Documents
Upload:	harshasud
View:	5 times
Download:	0 times

MEE - 1 - INTRO(2014)

Documents