ECON F243: MACROECONOMICS

No single piece of macroeconomic advice given by the

experts to their government has ever had the results
predicted.
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Recapitulation of the last
class
Highlighted the scope of macroeconomics along wih
the variables.
Discussed the goals, importance and strategy of the
Course
Discussed the brief outline of the course handout
Discussed the important questions of
macroeconomics
Why do we need to study Macroeconomics; As an
investor, as a planner, as a Manager and as an
intellectually curious person.

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As an Investor

Where are the interest rate heading?

Which sector will do best/worst during the next quarter,
year or decade?
What is the interest rate?
Why are Banks reducing interest rates?
What is inflation? What are the measures of inflation in
India?
What is the investment sentiments in the economy?
What is the exchange rate currently.
Which economy we have better investment avenues?

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As a Planner
What determines the interest rates and what are
appropriate monetary targets?
What the appropriate monetary tools to apply?
What are the appropriate taxes to raise?
What is the composition of best budget?
How will international trade affect jobs, inflation and
credit?
What is the cost of inflation?
What is the cost of fiscal deficit?
What is the cost of unemployment?
What is the cost of depreciation of the domestic
currency?

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Manager and Employee

What growth will my current market provide if I maintain

the share?
Can I raise my prices as rapidly as costs?
What opportunities are emerging in the emerging and
developed countries.
Should I recruit more or not?
What is the relationship between wage and profit?
Which sector I will target for investment and growth?

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Intellectually curious
person
Why do business cycle exist?
Why inflation?
How be inflation cured?
Why exchange rate is unstable?
What is interest rate?
Why interest rate is so important?
Why financial market is unstable?
And so on……

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Macroeconomic models

• Variables are exogenous/endogenous:

• Endogenous variables are the variables whose values
are determined by the model.
• A dependent variable is endogenous
• Exogenous variables are those whose value is
determined by forces outside the model.
• Macroeconomic theory will help us to identify those
variables from the system and establish the theoretical
linkages between those two set of variables.

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 Macroeconomic models
• Variables are exogenous/endogenous:
• Endogenous variables are the variables whose
values are determined by the model.
• A dependent variable is endogenous
• Exogenous variables are those whose value is
determined by forces outside the model.
• Macroeconomic theory will help us to identify
those variables from the system and establish the
theoretical linkages between those two set of
variables.
 Policy Questions in Macroeconomics

• Do you believe that interest rate decrease will

increase growth?
• Are you expecting the monetary authorities to
leave inflation unchecked for better economic
growth?
• Do you suggest the economies should not bother
about fiscal deficits and current A/C deficits?
• Should the economy try to have more
employment or less inflation?
 Chapter 2:
Classical Macroeconomics:
Output and Employment
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Classical Macroeconomics
Macroeconomics originated in 1930s after the great
depression in 1929.
The problems of great depression added urgency to the
study of macroeconomic questions.
The book containing the theory, “The General Theory of
Employment, Interest and Money” by J M Keynes
published in 1936.
The process of change in economic thinking that resulted
from this work has been called Keynesian Revolution.
But Revolution against what?
What was the old orthodoxy?
Keynesian termed it as the “Classical Economics”

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Classical Macroeconomics
And it is this body of macroeconomic thought that we will
study in this chapter.
J M Keynes termed “Classicals” to refer all the economists
who had written macroeconomic issues before 1936.
They are;
▪ Adam Smith Wealth of nations 1776
▪ David Ricardo Principles of Political Economy
1817
▪ John Stauart Mill Principles of Political Economy
1848
▪ A Marshall Principles of Economics 1920
▪ A C Pigou Principles of Economics 1933.

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Classical Revolution Bullionism is an economic theory that defines
wealth by the amount of precious metals owned..

• To classical economist, the equilibrium level of output

when actual level of output is equal to potential level of
output.
• Classical economics emerged as a revolution against a
body of econometric doctrine known as “Mercantilism”.
• Two tenets of mercantilism are (1) bullionism and (2)
Capitalism
• Adherence to these tenets, led countries to secure more
export, more materials, gold and silver through trade and
have favorable trade.
• State action was felt necessary to develop capitalist
system.
• Foreign trade was carefully regulated.

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Classical Revolution

• In contrast to mercantilism, classical emphasized the

importance of real factors in determining the wealth of
nations.
• Money acts as the means of exchange. Most questions
in macroeconomics were answered without analyzing the
role of money.
• The growth of the economy was the result of the stock of
factors of production and the advancement of techniques
of production
• Classicals mistrusted the role of Government in the
economy and belief in the free market mechanism.

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Classical Macroeconomics

Classical economists emphasized;

1. The importance of real factors in determining the wealth

of nations
2. They believe on the free-market mechanism concepts
3. Money plays the role of facilitating transactions as the
medium of exchange
4. They also mistrusted the role of government
5. Stressed the role of individual self interest in solving
macroeconomic issues.

We turn to the models constructed by classical economists

to support for these positions.
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Classical Theory of Output
and Employment - Outline

The Production Function

The Demand for Labor
The Supply of Labor
Labor Market Equilibrium

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The Production Function

The central relationship in the classical model is

production function.
The production function summarizes the relationship
between total output and total input assuming a given
technology.
Y = F (K, N) …(1)
– Parameters;
• Y = total output
• K = stock of capital
• N = quantity of labour

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Employment
Classical economists assumes that quantity of
labour is determined by forces demand and supply
in the labour market.
The hallmark of classical labour market analysis is that
– Market works well
– Firms and individual workers optimize their decisions.
– They have perfect information about relevant prices.
– There are no barriers to the adjustment of money
wages; i.e. market clears.
❑ The purchasers of labour services are firms. To see
how aggregate demand for labour (employment) are
decided, we begin considering the labour demand for
individual firm (ith Firm).

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Demand for Labour

In short run, output is varied solely by changing labour

input so that choice of level of output and quantity of
labour inputs are one decision.
The perfectly competitive the firm owner will employ the
labour till the point where the marginal cost of producing
a single output = marginal revenue received from its
sale.
For perfectly competitive firm the marginal revenue is
equal to the product price.
Hence, the equilibrium employment are obtained by
equalizing marginal cost of producing a single output
with price of product.

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Demand for Labour i means calculating for 1 firm, i th firm

• MC = marginal labour cost (labour is the only input)

• MCi = W/MPNi
• W = wage and
• MPN = number of units produced by additional units of
labour.
• With the condition of profit maximization as P is the price of product
• MCi = P; W is cost of getting labor
that is wage
• P = W/MPN
• Or W/P = MPNi
• Or W = MPN.P (MRPN)
• So, the firm owner will hire up to the point where
revenue obtained from additional output produced by
one more worker (MPN.P) is equal to the money wage
paid to the worker.

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Demand for Labour

❑ How much labor do firms want to use?

– Analysis at the margin: costs and benefits of hiring one

extra worker
• If real wage (w) > marginal product of labor (MPN),
profit rises if number of workers declines
• If w < MPN, profit rises if number of workers increases
• Firms’ profits are highest when w = MPN
• Note: w = (W/P)

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BITS Pilani, Pilani Campus
Summary

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