Macroeconomics

Course Outline
• Nature and Scope of Macroeconomic
• National Income: Concept and Measurement
• Classical Theory of Output and Employment
• Keynesian Theory of Income Determination: A simple economy model
• Macroeconomic Equilibrium
• Income Determination in Closed and Open Economy
• The Investment Functions
• Theories of Interest Rate (Money Market Equilibrium)
• IS and LM Function: General Equilibrium of Product and Money Markets
• Theories of Inflation
• Theories of Economic Growth
• Business Cycles
• Fiscal and Monetary Policies
 1.1 Nature and Scope of Macroeconomics

• 1.1 Economics
• The term economics is derived from the Greek word Oikos – for house
or settlement, nomos for laws or norms; hence related to household
management.
• Generally economics is a branch of social science which studies human
activity in allocation of scarce resources in production and distribution
of goods and services to satisfy unlimited wants of the society.
• The subject economics is divided into two main branches: i)
microeconomics and ii) macroeconomics.
• The prefix ‘macro’ in the word macroeconomics is derived from the
Greek word ‘makros’ meaning large
•
1.1 What is Macroeconomics?
• It is believed that Norwegian Noble Laureate Ragnar Frisch was first to
economist to coined the word macroeconomics in 1933.
• But it emerged as a separate branch in 1936 with the publication of JM
Keyne's book, referred as The General Theory.
• RGD Allen - The term ‘macroeconomics’ applies to the study of
relations between broad economic aggregates’.
• Culbertson, ‘Macroeconomics theory is the theory of income,
employment, prices and money’.
• KE Boulding ‘Macroeconomics is that part of economics which studies
the overall averages and aggregates of the system’.
 1.1.1 Cont… Defining macroeconomics

• Gardner Ackley: “Macroeconomics is the study of forces or

factors that determine the levels of aggregate production,
employment, and prices in an economy, and their rates of
change over time.
• So it studies the behavior and performance of the economy as a
whole.
• It studies the level & growth of national output and
employment, general price level, balance of payment of an
economy.
1.2 Basic issues in Macroeconomics
• What economist look for in economy – basic issues of
macroeconomics
• 1) GDP / GDP growth
• 2) Inflation
• 3) Unemployment level
• 4) Business cycle
 1.2 cont.. Economic growth

• It is the rise in real GDP/GNP or per capita income of the economy.

• Achieving high and sustained economic growth is a central
macroeconomic issue.
• Higher economic growth means betterment of living standard of the
people.
• Economic growth is indicated by increase in the quantities of the
resources- labor, capital, land and entrepreneurship – used to
produce goods and services.
• The problem of stagnant growth arises when aggregate supply is not
increasing at a desired rate.
• An increase in the total production of goods and services is generally
needed to catch up with the increase in the population of society and
expectations of a rising living standard.
 1.2 cont.. Inflation

• Inflation is a situation whereby the price of goods and services rises

continuously.
• Inflation occurs when average price level of the economy rises
continually.
• It leads to fall in purchasing power of financial assets and financial
wealth of the people – leading to decline in living standards.
• There is uncertainity in the business environment. So income and
wealth get unequally distributed.
• Control of inflation or keeping inflation at low level is another
economic issue.
• Therefore every economy tries to achieve stable price level.
 1.2 cont… Unemployment
•  Unemployment/ unemployed – temporary lay off, looking for a job;
waiting for start date
• Not in labor force = full time student, homemaker or retiree
• Labor force – total no. of workers = employed + unemployed

• Unemployment rate

• Labor force participation

1.2 cont… Cont…

• Full employment is achieved when all available resources are used to

produce goods and services.
• It is indicated by the employment of labor resources (can be measured
as unemployment rate).
• The economy benefits from full employment of resources because they
satisfy wants and needs – reduction of scarcity problems.
• Labor being most active factor of production – is an indicator of
employment.
• increase in unemployment have economic and social costs.
• It becomes difficult to address scarcity problems, less income and lower
level of living standard.
1.2 cont.. unemployment

• Categories of unemployment:
• - natural rate of unemployment – long run - constant
• - cyclical unemployment – short run concept – short term ups and
downs of business cycles
 Unemployment from a Wage Above the Equilibrium Level

Wage

Labor
Surplus of labor =
supply
Unemployment
Minimum
wage

WE

Labor
demand

0 LD LE LS Quantity of
Labor

Copyright©2003 Southwestern/Thomson Learning

1.2 cont.. What is a business cycle?

• Business cycles are fluctuations in the aggregate

economic activity, generally concerned with the
economy as a whole. These fluctuations that recur
with regularity.
• Shumpter, defines business or trade cycles as, ‘ the
wave like deviations in the level of business activities
from the equilibrium or trend line
• ‘Trade cycles are regular upturn and downturn in all
economic activities like aggregate employment,
income, output and price level; known as boom or
slump in the economy
 1.2 cont.. Features or characteristics of
Business cycles
• Periodic or regular – may occur periodically at regular
interval of 10 to 12 years and all phases come regularly
• It covers all the sectors of the economy – may start from one
sector and spread over all other sectors
• It is international or universal; may start from US and spread
all over the world
• Process of expansion and contraction are self reinforcing
• Affects different people of the society differently
 1.2 cont.. Phases of Business cycle
• Depression – considerable reduction in production of goods/s,
employment, income, demand and prices
• Fall in bank deposit,
• Mass unemployment, fall in general price level, wages, profits, wages
and interests

• Trough – lowest point of depression or lower point of aggregate

economic activity
• May be short lived
• Its end pave the way to revival
• Recovery Phase- is also called revival
• Increase in business activity after lowest point of depression
• Once started the levels of employment, income and output rise
steadily
 1.2 Cont.. Business cycle
• Prosperity Phase - In this phase, demand, output, employment and
income are at the high level
• They tend to raise prices; but wages, salaries, interest rates, rentals
and taxes do not rise in proportion to general price
• The peak or boom – upper turning of trade cycle
• National income is at the highest
• It is likely that economy would working beyond the full
employment level
• Continue investment even after the stage of full employment would
result:
• Scarcity of labor, raw materials, leading to rise in costs
• Rise in interest rates
• Failure of consumption to rise
• Additional pressure on factors of production
• No. of jobs exceeding no. of workers
1.2 Cont… business cycle

• Recession Phase
• When there is downturn from the peak or boom ( last for short
period)
• Its outer signs are strain on banking system and increase in bad
debts of banks, and begining of declining of prices
• Decline in profit margin
• Costs start overtaking prices
• Investment, income and demand declines
• Contraction Phase – recession and depression phases;
unemployment rises, general price levels fall; type of capital goods
falls
• Expansion phase- comprises recovery and prosperiety
 Business Cycle
Real GDP

Peak
per year

Peak

y
rit
Re

pe
ce

os
ss

Pr
io
n

y
er
De

v
pr

co
es

Re
si
on
Trough

Time Period
One cycle
 1.2 Cont… Business cycles summary
• It arises due to rise and fall in total output, income and
employment of an economy. It is a regular pattern of expansion
(recovery) and contraction (recession) in economic activity
around the path of trend growth.
• Economies try to control the ups and downs in aggregate
economic activities. An economy is stabilized by limiting
fluctuations in production, employment and prices. There are
two primary phases of the business cycles –
• Contraction: It is a general decline in economic activity. Aggregate
demand is less and output falls – it leads to unemployment
problem. The economic depression of 1930s and the recent
2007/08 depression in countries like US & western European
countries.
• Expansion: It is a general rise in economic activity. Aggregate
demand is high and may exceed ability the of the economy to
supply. Inflation tends to be a primary problem in such a
situations.
1.3 Distinction & interdependence
between Micro & macro economics
• Microeconomics is concerned with individual entities such as markets,
firms, and households. It deals with settings of individual prices like wages
of labors, rent of land and other assets, interest of money borrowed and
lent. The prefix micro is derived from Greek word Mikros, which means
small.
• According to Boulding “Microeconomics is study of particular firm,
particular households, individual prices, wages, incomes, individual
industries, particular commodities.”
• The major study areas are : Theory of consumer behavior, Theory of
demand and supply, theory of production and costs, Theory of firms,
Theory of product pricing, Theories of factor pricing .
• Macroeconomics analyses economic measures of total output, total
employment, total income, aggregate expenditures, and general price level.
Micro economics studies from individual perspective while
macroeconomics studies from aggregate perspective.
 1.3 cont… Distinction: Micro & Macro
Fields Micro
Production Individual firm, industries,
business
Price Price of individual goods/s
(price of petrol, food etc.)
Income Distribution of income &
wealth (wage in private
hospital, a factory, salary
in bank)
Employment Jobs in industry, no. of
employees in firm
Macro
National output, GDP,
World GDP
Aggregate price level
(consumer & producer
price, inflation)
National Income (total
wages & salaries, total
corporate profits)
Employment &
unemployment in economy
(total jobs in economy,
unemployment rate in
Nepal)
1.3 Interdependence: Micro &
macroeconomics
• Microeconomic theories provide building blocks for the aggregate
theories and macroeconomics
• Macroeconomic theory has foundation in macroeconomic theory
• The problem of Pokhara Metropolitan city are macro in nature to
those of individual citizens, but a metropolitan is micro as compared
to the province no. 5, and province 5 is micro unit compared to
national. Nepal’s economy is micro in the context of global economy.
• Macroeconomics also affects microeconomics: a change in tax rate
made from macro perspective affects firms pricing and investment
decision; central banks decision on bank rate policy affects borrowing
and lending of individual commercial banks
1.4 Circular Flow in the Economy
• Circular flow – movement of production, income,
and the services between producers, resource
suppliers and consumers.
• Concerned about recurring flow of products, factors
and money among the households, business,
government and foreign sectors, through product,
resources and financial markets.
• Aggregate macroeconomic sectors: households,
businesses, government and foreign sectors
1.4 Cont… Household sector

• What is a household ?
• A group of people who are living together under one
roof and eating atleast one meal together. (CBS Nepal)

• Primary economic functions of Household sector:

• - consumption of GDP,
• - selling factor services, and
• - paying taxes to the government
• = consumption expenditure in GDP
 1.4 cont.. Business sector

• Business sector includes corporations, proprietorships and

partnerships
• They are Profit motivated
• They Produce goods and services
• Major activity : production, hire factors (land, labor, capital
& enterpreneurships), pay taxes to the government
• = investment expenditure in GDP
1.4 cont.. Government sector

• Government sector has the obligation and right to

prepare and implement fiscal and monetary policy
• At times it also regulates the economy
• It has an exclusive power to fix and levy various tax
• It decides the macroeconomic direction of the
country
• Primary function: collecting and spending tax
revenue; establish laws and rules
• it can influence economy via tax spending
• Government spending (G)
1.4 cont… Foreign sector

• It comprises the external relationship of a country

• A country’s most important relationship with the external sector
arises with foreign trade
• Foreign trade comprises of exports and imports
• Export (X) : sale of goods and services produced by the domestic
country to other countries of the world
• Import (M) : purchase of goods and services produced by foreign
countries
• Generally export is carried by business sector of a country
• Import is done by business and government sectors
• The net trade balance or external balance is shown by X-M
 Three markets of macroeconomic sectors
• Product Market:
• -exchange of final goods & services; four buyers – Household, Business,
government & foreign sectors
• -Seller – primarily – Business sector
• Factor Markets
• - exchange of services of factors like – land, labor, capital & entrepreneurship
• - land, labor & capital traded in factor market
• - entrepreneurship creates firms and other factors
• -Resources used by business sector
• - payment of these services received by household sector
• Financial market
• - lending & borrowing to finance physical capital
• -financial capital – fund firm use to buy physical capital
• - stock market, bond market
• - supply of financial capital depend on people’s saving decision
Two sector: goods and factor markets
(3) (2)
Factor Producer
demand supply

Factor Goods
services
P P
S S
PF 2
P2
PF 1 P1
D2 D2
D1 D1
O QF1 QF2 Q O Q1 Q2 Q

Factor
services Goods
(4)
(1)
Factor
Consumer
supply
demand
 3 sector circular flow

INJECTIONS

Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV.
payments produced goods
and services (Cd)

Net
Net taxes (T)
saving (S)

WITHDRAWALS
 The circular flow of income

INJECTIONS

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
 Supply of Products Foreign
Markets

Purchases Products
of Products Market
Products
Services Services

Households Businesses
Government
Taxes Taxes

Resource
(Inputs)
Supply of Labor and Resources Market

Purchases of (Demand for) Labor and Resources

End task

• Please explain 2 sector, 3 sector and 4 sector circular flow diagrams