MACROECONOMICS

(ECON 2031)

By: Habtamu Legese

August 2021
 CHAPTER ONE
INTRODUCTION
Section 1. Definition and concepts of Economics

What is Economics?

Economics can be defined in different ways. The

following are the major ones.
Cont.
1) Economics is a social study of production, distribution, and
consumption of wealth or output.
2) Economics is a study of choice. Economic agents make choice
because of scarcity, constraints or limitations of resources.
There are two major types of constraints or limitations.
i. Economic constraints or limitations includes
A. Costs of production
B. Opportunity costs
C. Income
 Cont.
ii. Non-Economic constraints : include climate conditions (such as
prevalence of drought), political factors (such as civil war or
conflict between countries) cultural factors, and religious factors,
customs and legal factors.
3) Economics is the study of decision-making.
a) What to produce
b) How to produce
c) For whom to produce
4) Economics is the study of wise and efficient use of limited resources
Economics is not the study of greedy or gluttonous
Section 2: Branches of Economics

What are the major branches of Economics?

What is the difference between Macroeconomics and

Microeconomics?

What are endogenous and exogenous variables?

What are the major branches of Economics?
For example, from the point of view of elements of analysis,
economics has two major branches:
a) Microeconomics and
b) Macroeconomics
Microeconomics deals with behaviors of individual economic
units such as consumers, producers, business firms and other
economic decision-making units.
Cont.
Macroeconomics deals with aggregate units of national
economy such as national output or Gross National Product
(GNP), general price level, inflation and national employment.
ii) From the viewpoint of method of analysis
Positive Economics is a branch of economics which is
concerned with the explanations of economic
conditions. It tries to answer the question “What?”

Normative Economics is a branch of economics,

which deals with value judgment on economic
situation. It tries to answer questions like “What
should be?”
iii) On the basis of the economic system a
country follows.
A) Command economy is the type economy where economic
variables (prices, output etc.) are controlled by the government.
B) Market economy is the type of economy where values of
economic factors are determined by market forces.
C) Mixed economy
Economic variables and their relationship
C = f(S, Y, HHS)………………................................……...(1.1)
The variable on the left hand side (C) is said to be:
 Endogenous variable,
 Dependent variable or
 Explained variable
The variables on the right hand side are known as:
 Exogenous variables,
 Independent variables,
 Explanatory variables or
 Determinant variables
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.
Macroeconomics 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.
Objectives of Macroeconomics
 Generating a high level of production of economic goods and
services for the population.
 High employment - providing jobs
A stable or gently rising level of price level with prices and
wages are determined by free markets.
 Foreign economic relations marked by a stable foreign
exchange rate and exports more or less balancing imports.
Cont.
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:
1. algebraic & geometric tools of analysis like differentiation & graphs;
2. models like AD-AS model & IS-LM model.
1.2 THE STATE OF MACROECONOMICS
1.2.1 Evolution and Recent Developments
 The Great Depression gave birth to modern macroeconomics as
surely as accelerating inflation in the late 1960s and early 1970s
facilitated the monetarist counter-revolution.
 It is also important to note that many of the most famous
economists of the twentieth century, such as Milton Friedman,
James Tobin and Paul Samuelson, were inspired to study
economics in the first place as a direct result of their personal
experiences during this period.
Cont.
Although it is important to remember that economists before
Keynes discussed about macroeconomic issues such as
business cycles, inflation, unemployment and growth.
The birth of modern macroeconomics as a coherent and
systematic approach to aggregate economic phenomena can be
traced back to the publication in 1936 of Keynes’s book “The
General Theory of Employment, Interest and Money”.
2.2 The Classical and Neoclassical Macroeconomics School
Classical economists were well aware that a capitalist
market economy could deviate from its equilibrium
level of output and employment.
However, they believed that such disturbances would
be temporary and very short-lived.
Their collective view was that the market mechanism
would operate relatively quickly and efficiently to
restore full employment equilibrium.
Cont.
 If the classical economic analysis was correct, then
government intervention, in the form of stabilization
policies, would be neither necessary nor desirable.
 Indeed, such policies were more than likely to create greater
instability.
 It follows that the classical writers gave little attention to
either the factors, which determine aggregate demand, or
the policies, which could be used to stabilize aggregate
demand in order to promote full employment.
Cont.
 For the classical economist’s full employment was the normal
state of affairs.
 But how did the classical economists reach such an
optimistic conclusion?
 We will present a ‘stylized’ version of the classical model
which seeks to explain the determinants of an economy’s level
of real output (Y), real wage (W/P) and nominal wages (W),
the price level (P) and the real rate of interest (r)
 In this stylized model it is assumed that:
Cont.
1. All economic agents are rational and aim to maximize their
profits or utility; furthermore, they do not suffer from money illusion
2. All markets are perfectly competitive, so that agents decide how
much to buy and sell based on a given set of prices, which are
perfectly flexible
3. All agents have perfect knowledge of market conditions and
prices before engaging in trade
Cont.
4. Trade only takes place when market-clearing prices have
been established in all markets
5. Agents have stable expectations
 These assumptions ensure that in the classical model, markets,
including the labor market, always clear.
2.3 The Keynesian Macroeconomics School
 For the early post-war years, the central distinguishing beliefs within
the orthodox Keynesian school can be listed as follows:
 The economy is inherently unstable and is subject to erratic
shocks.
 These shocks are attributed primarily to changes in the marginal
efficiency of investment following a change in the state of business
confidence, or what Keynes referred to as a change in investors’
‘animal spirits.
Cont.
 Left to its own devices the economy can take a long time to
return to the neighborhood of full employment after being
subjected to some disturbance; that is, the economy is not
rapidly self-equilibrating.
 The aggregate level of output and employment is essentially
determined by aggregate demand and the authorities can intervene to
influence the level of aggregate ‘effective’ demand to ensure a more
rapid return to full employment.
Cont.
 In the conduct of stabilization policy, fiscal as opposed to
monetary policy is generally preferred.
 The effects of fiscal policy measures are considered to be more
direct, predictable and faster on aggregate demand than those
of monetary policy.
 These beliefs found expression in the orthodox Keynesian
model, known as the IS – LM model.
Cont.
In the General Theory, Keynes sets out to discover the
determinants national income of a given system and
the amount of its employment.
In the framework he constructs, the national income
depends on the volume of employment.
In developing his theory, Keynes also attempted to
show that macroeconomic equilibrium is consistent
with involuntary unemployment.
Cont.
 The theoretical novelty and central proposition of the book is
the principle of effective demand, together with the
equilibrating role of changes in output rather than prices.
 The emphasis given to quantity rather than price adjustment
in the General Theory is in sharp contrast to the classical
model, where discrepancies between saving and investment
decisions cause the price level to oscillate.
2.4 The New Classical Macroeconomics School
 During the early 1970s, there was a significant renaissance of
the belief that a market economy is capable of achieving
macroeconomic stability.
 In particular the ‘Great Inflation’ of the 1970s provided
increasing credibility and influence to those economists who had
warned that Keynesian activism was both over ambitious and,
more importantly, predicated on theories that were
fundamentally flawed.
The central working assumptions of the new classical
school are three:
1. Economic agents maximize
 Households and firms make optimal decisions.
 This means that they use all available information in
reaching decisions and that those decisions are the best
possible in the circumstances in which they find
themselves.
Cont.
2. Expectations are rational, which means they are statistically
the best predictions of the future that can be made using the
available information.
 Rational expectations imply that people will eventually come
to understand whatever government policy is being used, and
thus that it is not possible to fool most of the people all the
time or even most of the time.
Cont.
3. Markets clear.
 There is no reason why firms or workers would not adjust
wages and prices if that would make them better off.
 Accordingly, prices and wages adjust in order to equate supply
and demand; in other words, markets clear.
Cont.
 One dramatic implication of these assumptions, is that there is no
possibility for involuntary unemployment.
 Any unemployed person who really wants a job will offer to cut his or
her wage until the wage is low enough to attract an offer from some
employer.
 Similarly, anyone with an excess supply of goods on the shelf will cut
prices so as to sell.
 Flexible adjustment of wages and prices leaves all individuals all the
time in a situation in which they work as much as they want and firms
produce as much as they want.
2.5 The New Keynesian Macroeconomics School
 During the 1980s, there was a growth of interest in the early Keynes
in order to better understand the later Keynes of the General Theory.
 The more recent attempts to explore the methodological and
philosophical foundations of Keynes’s political economy have been
termed ‘the new Keynes scholarship.’
 The
new Keynesians, mostly trained in the Keynesian tradition but
moving beyond it, emerged in the 1980s.
 They do not believe that markets clear all the time but seek to
understand and explain exactly why markets can fail.
Cont.
 The new Keynesian argues that markets sometimes do not
clear even when individuals are looking out for their own
interests.

 Both information problem and costs of changing prices lead

to some price rigidities, which help cause macroeconomic
fluctuations in output and employment.
Cont.
 For example, in the labor market, firms that cut wage not only reduce
the cost of labor but also are also likely to wind up with a poorer
quality labor force. Thus, they will be reluctant to cut wages.
 If it is costly for firms to change the prices they charge and the wages,
they pay, the changes will be infrequent;
 But if all firms adjust prices and wages infrequently, the economy wide
level of wages and prices may not be flexible enough to avoid
occasional periods of even high unemployment.
Thank You