INTRODUCTION

Dr Alka Chadha
Assessment
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End-term exam- 40%
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Definition
◦ “Macroeconomics is the study of the behaviour of the economy as a whole. It
examines the overall level of a nation’s output, employment and prices.”
- Paul A. Samuelson and W. D. Nordhaus
Major issues
◦ Macroeconomics is concerned with the behaviour of the economy as a whole—with
booms and recessions, the economy’s total output of goods and services, the growth
of output, the rates of inflation and unemployment, the balance of payments, and
exchange rates.
◦ Macroeconomics deals with both long-run economic growth and the short-run
fluctuations that constitute the business cycle.
◦ Macroeconomics focuses on the economic behaviour and policies that affect
consumption and investment, the trade balance, the determinants of changes in
wages and prices, monetary and fiscal policies, the money stock, the union budget,
interest rates, and the national debt.
◦ In brief, macroeconomics deals with the major economic issues and problems of the
day.
Foundations
◦ Classical economists: If market forces are allowed to work freely, national income will be
determined at the full employment level, there will always be full employment in the long run
and no disequilibrium in the long run. Starting from Adam Smith to 18th-19th century
economists like David Ricardo, Robert Malthus, Alfred Marshall, John Stuart Mill.
◦ Keynesian economists: John Maynard Keynes led the criticism of laissez-faire system in his
book “The General Theory of Employment, Interest and Money (1936). Aggregate demand
determines output, employment, interest rate and money market equilibrium. Unemployment
is caused by demand deficiency that can be removed by govt spending. Role of demand
management by the govt for stable growth. Instead of crowding out private investment, it
has a multiplier effect. Keynesian theories laid the foundation for macroeconomics. Period
from 1930s to 1960s is called Keynesian revolution or Keynesian era, policies adopted by govts
around the world.
◦ Monetarists: In 1970s, fiscal measures fail to solve stagflation. Milton Friedman said role of
money supply is the main determinant of output and employment in short run and price level
in long run. Role of monetary management.
◦ Neo-classical economists or radicalists: Robert E. Lucas focussed on the role of rational
expectations about future economic events. People’s expectation about monetary and
fiscal policies determine AD and AS such that output remains unaffected but prices and
wages go up.
◦ Supply-side economists: Arthur Laffer emphasized the role of factors operating on the supply
side of the market. A tax cut would shift out aggregate supply and increase output and
employment (Laffer curve). Role of fiscal policy, just like Keynesians.
Micro vs macro
◦ Microeconomics studies the behaviour of individual economic units, such as
households and firms, or the determination of prices in particular markets.
◦ In macroeconomics, we deal with the market for goods as a whole, treating all the
markets for different goods as a single market. We deal with the labour market as a
whole, abstracting from differences between the markets for unskilled labour and
doctors. We deal with the assets market as a whole.
◦ The benefit of the abstraction is that it facilitates increased understanding of the vital
interactions among the goods, labour, and assets markets and the interactions among
national economies that trade with each other.
Goals and instruments
◦ High level of output, high employment with low voluntary unemployment and stable
prices.
◦ Govts have certain instruments that they can use to affect macroeconomic activity.
◦ A policy instrument is an economic variable under the control of the govt that can
affect one or more of the macroeconomic goals.
◦ Instruments of fiscal and monetary policies are used to avoid the worst excesses of the
business cycle.
◦ Fiscal policy deals with govt expenditures and taxation.
◦ Monetary policies deal with regulating financial institutions and buying and selling
bonds.
Growth and Downturns
◦ The growth rate of the economy is the rate at which the gross domestic product (GDP) is
increasing.
◦ Growth occurs as the amount of resources (L and K) available in the economy changes and
as efficiency of factors of production changes (productivity increases).
◦ Over time, FoP change and the same FoP can produce more output. Productivity increases
result from changes in knowledge, as people learn through experience to perform familiar
tasks better, and as new inventions are introduced into the economy.
◦ The short-term fluctuations in output, employment, financial conditions and prices is called
business cycle.
◦ Long-term trends in output and living standards in called economic growth.
◦ During downturns, actual GDP falls below its potential and unemployment rises.
◦ A recession is a period of significant decline in total output, income and employment,
usually lasting for more than a few months and marked by widespread contraction in many
sectors of the economy.
◦ A depression is a severe and protracted downturn.
Business cycle
◦ Inflation, growth, and unemployment are related through the business cycle . The
business cycle is the more or less regular pattern of expansion (recovery) and
contraction (recession) in economic activity around the path of trend growth.
◦ At a cyclical peak, economic activity is high relative to trend; at a cyclical trough , the
low point in economic activity is reached. Inflation, growth, and unemployment all
have clear cyclical patterns.
◦ The trend path of GDP is the path GDP would take if factors of production were fully
employed. Over time, GDP changes as more resources become available: The size of
the population increases, firms acquire machinery or build plants, land is improved for
cultivation, the stock of knowledge increases as new goods and new methods of
production are invented and introduced. This increased availability of resources allows
the economy to produce more goods and services, resulting in a rising trend level of
output.
Business cycle

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Output gap
◦ Factors are not fully employed all the time. Full employment of factors of production is
an economic, not a physical, concept.
◦ Output is not always at its trend level, that is, the level corresponding to (economic) full
employment of the factors of production. Rather, output fluctuates around the trend
level. During an expansion (or recovery) the employment of factors of production
increases, and that is a source of increased production. Output can rise above trend
because people work overtime and machinery is used for several shifts.
◦ During a recession unemployment increases and less output is produced than could in
fact be produced with the existing resources and technology.
◦ Deviations of output from trend are referred to as the output gap . 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 .
Potential GDP
◦ Potential GDP represents the maximum sustainable level of output that an economy can
produce. It is the level of output corresponding to full employment of the labour force and
capital stock.
◦ It is determined by an economy’s productive capacity which depends upon the inputs
available and technological efficiency.
◦ It grows over time as the economy accumulates resources and as technology improves.
◦ Potential GDP tends to grow steadily because inputs like L, K and technology change quite
slowly over time whereas actual GDP is subject to large business-cycle swings if spending
patterns change sharply.
◦ Actual GDP is obtained directly from the data but potential GDP is an analytical concept
derived from actual GDP and unemployment data.
◦ A recession is a period between a peak and a trough, and an expansion is a period
between a trough and a peak. During a recession, a significant decline in economic activity
spreads across the economy and can last from a few months to more than a year.
Business cycles vs growth
◦ Business cycle analysis focuses on high frequency movements of Y (quarter, year).
◦ Economic growth analysis focuses on the evolution of Y* over time (decade, centuries).

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Unemployment
◦ Active labour force includes all employed persons and those unemployed persons who
are seeking jobs.
◦ Unemployment rate is the percentage of labour force that is unemployed.
◦ When output is falling, the demand for labour falls and the unemployment rate rises.
◦ Due to unemployment, potential output is going to waste, and thus the reduction of
unemployment is desirable.
◦ Unemployment rate reflects the state of the business cycle. During the Great
Depression (1929-39), unemployment increased from 3% in 1929 to 25% in 1933,
production of goods and services declined by 30%, inflation fell by 30% and business
investment was almost nil.
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Inflation
◦ During booms and wartime, output can be temporarily above its potential as capacity
limits are strained, but high utilization may lead to inflation, that can be addressed by
monetary and fiscal policies.
◦ Price index is a measure of the overall price level.
◦ Consumer Price Index (CPI) measures the trend in the average price of goods and
services bought by consumers.
◦ Inflation rate is the change in the overall level of prices from one year to the next.
𝑃𝑡 −𝑃𝑡−1
Rate of inflation in year 𝑡 = 100 x
𝑃𝑡−1
◦ In the case of inflation, there is no obvious loss of output but it reduces the efficiency of
the price system.
Price stability
◦ Price stability is defined as low and stable inflation rate.
◦ It is required because a smoothly functioning market requires that prices accurately
convey information about relative scarcities.
◦ A deflation implies that rate of inflation is negative or prices are declining.
◦ Hyperinflation is the extreme rise in the price level of a thousand or a million percent a
year. Brazil in 1980s, Russia in 1990s or Zimbabwe in 2000s. Prices are meaningless and
the price system virtually breaks down.
Fiscal policy
◦ Govt expenditure include purchases and transfer payments.
◦ Govt purchases include spending on goods and services (quid-pro-quo).
◦ Govt transfer payments increase the incomes of targeted groups such as the elderly or
unemployed (no quid-pro-quo).
◦ Taxes affect people’s disposable incomes i.e. affect spending and private saving.
Private consumption and saving have important effects on investment and output in
the short and long run.
◦ Taxes also affect prices of goods and factors of production and thereby affect
incentives and behaviour.
Monetary policy
◦ Govt manages the nation’s money, credit and banking system.
◦ The central bank affects the economy by determining interest rates by setting short-run
interest rate targets and buying and selling govt securities to attain those targets.
◦ RBI influences interest rates, stock prices, housing prices and forex rates, which in turn
affect housing, investment sentiment, exports and imports.
◦ RBI raises interest rates when inflation is too high that results in reduced investment and
consumption causing a decline in GDP and lower inflation.
◦ RBI lowers interest rates during slowdowns, provide credit and extend lending facilities.
◦ Monetary policy is most often relied on to stabilize the business cycle, but is less potent
in deep recession.