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Chapter I: Introduction
Economics as a science is usually
classified in to two broad branches as:
Microeconomics: studies the behavior of
individual decision making units.
Individual consumers, firms, industries, resource owners, etc.
Macroeconomics: studies the aggregate
behavior of the economy.
National Income, Unemployment, Inflation, Economic Growth,
etc.
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Cont…
Microeconomics and Macroeconomics are a
highly interrelated branches of economics and
the concepts of Macroeconomics are mostly
based on the solid foundations of
Microeconomics.
Macroeconomics always tries to measure
economic variables at the aggregate level and
build a relationship between them in order to
explain the functioning of the overall economy.

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Macroeconomic Objectives

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Evolution of Macroeconomics
Macroeconomics as a separate branch of
economics comes to the picture only in the
1930s.
Before the 1930s, there was no clear distinction
between Microeconomics and Macroeconomics.
The Great Economic Depression that started in
1929 and the British economist John Maynard
Keynes‘s book “The General Theory of
Employment, Interest and Money” published
in 1936 has added the urgency to a separate
branch of Economics called Macroeconomics.

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Macroeconomics and Different
Economic school of thoughts

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The Classical School of thought
☞The first modern school of thought.
☞The major contributors are: Adam Smith,
David Ricardo, Thomas Robert Malthus,
John Stuart Mill, Alfred Marshal and Irving
Fischer.
☞Emerged as an attack on an earlier
Mercantilist view, who believed in stock of
precious metals (Gold and Silver) as
determinant of wealth of a nation and strong
role of the state action in the development of
the capitalist state.
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Cont…
☞Strongly belief in the market and the
efficacy of the price mechanism.
◦ Supporters of Say's law (developed by a
French economist Jean Baptiste Say)
"Supply creates its own demand"
☞The government should not interfere in
economic activities.
☞They ignore factors that determine the
overall demand for commodities or to
policies that regulate aggregate demand (i.e.
fiscal or monetary policies).

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Cont…
☞For the Classical economists, the short run
aggregate supply curve is vertical, assuming
the productivity of labor, technology,
availability and prices of natural resources
constant.
 Hence, whatever the shape or position of the aggregate
demand curve; it would clearly not affect output level.
Only Supply side policies could affect the
real wage, employment and output levels.
Demand side policies affect only nominal
variables like interest rate and price levels.

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Cont…
Aggregate Price AS

P2

P1
AD2
AD1

0 Y0 Aggregate Output

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The Keynesian School of Thought
The major contributors are: John Maynard
Keynes, James Tobin, John Hicks and Paul
Samuelson.
Keynesian economics developed against the
background of world depression in 1930’s.
Till the world Great Depression, the
economy of the western countries were
moving smoothly as the Classical economists
believed; full employment, smooth financial
flows, and so on ............, Say's law working.

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Cont…
But, during this time, businessmen lose
confidence and start to think of potential
investments as risky, leading them to hesitate
to invest and accumulate cash instead; which
in turn lead the households to cut their
consumption expenditure and hold more cash
because of the related job uncertainties.
The amount of cash in the economy is fixed,
when both the households and businesses hold
more of the fixed cash income will fall along with
spending.
Ultimately factories will close down, workers will
laid off, stores empty, etc.

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Cont…
Keynesians recommendation:
◦ To make it possible for people to satisfy their
demand for more cash with out cutting their
spending:
1. Expansionary monetary policy: print and inject
some amount of money in the circulation. But this
may not be enough when the recession in severe
and that is what Keynes calls the liquidity trap.
2. Expansionary Fiscal Policy: The government has
to do what the private sector will not, i.e. by
increasing its expenditure.
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The Monetarist School of Thought
Dates back to Milton Friedman's "Restatement of
the quantity theory of money" in 1956.
Advocates free market like the classical
economists.
Attacked Keynes idea of smoothing business
cycle on the ground that such active demand
management policy is not only unnecessary but
indeed likely to be harmful, worsening the very
economic instability that it is supposed to correct,
and should be replaced by simple, mechanical
monetary rules.

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Cont…
For Friedman, recession did not arise
because the private sector was trying to
increase its holdings of a fixed amount of
money. Rather, they occurred because of
a massive contraction of the quantity of
money in the circulation.
Fiscal policy is useless since the interest
sensitivity of investment is high and thus
consequently, fiscal policy leads to a
strong crowding out of investment.

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 Cont…
Though, Monetarists are supporters of free market
mechanism they do believe that that the economy
could be out of full employment level in the short
run; an idea quite in contrast to the classical
economist ideology.
If economic slumps begin when people
spontaneously decide to increase their money
holdings, then the monetary authority must
monitor the economy and pump money in when it
finds a slump is imminent. According to them,
such changes in money supply will have
temporary effect on out put only in the short run.
But in the long run it has no effect on the real
sector (Long run monetary neutrality). 16
 The New Classical School of Thought

The major contributors are: Robert Lucas,

Thomas Sargent, and Robert Barro.
Some times called the rational expectation
school of Economics.
Developed against the background of high
inflation and unemployment of the 1970’s
and the accompanying dissatisfaction with
the prevailing Keynesian explanation and
have remained influential in the 1980s till
now.
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Cont…
Stabilization of real variables such as
output and employment can’t be achieved
by aggregate demand management, i.e.
ineffectiveness of monetary and fiscal
policies over real variables.
Individuals act rationally in their self-
interest in markets that adjust rapidly to
changing conditions. The government, it
is claimed, is likely only to make things
worse by intervening.

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Cont…

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Cont…
The focal point of distinction between the
Keynesians ( and Monetarist) and the new
classicals is on modeling expectation which
the latter use forward looking nature of ration
expectation in contrast to the Keynesians
backward looking expectation.
For the new classical school economists, the
effect of policy depends on whether they are
anticipated or unanticipated policy changes.

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Cont…
In the case of anticipated expansionary
monetary policy change, perhaps because the
policy maker announced the policy change;
unlike the Keynesians and monetarist will have
an impact on both the demand and supply side,
increment in the aggregate demand but a decline
in aggregate supply which will result both
output and employment to remain at the original
position. Hence such policies are not effective in
affecting the real variables even in the short run.

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Cont…
But, the analysis would be similar to the
Keynesians in cases of unanticipated
monetary policy changes affect output and
employment in the short run. This occurs
because agents don’t perceive the policy
change and thus won’t react on it. That is,
it is only the aggregate demand that will
shift with the aggregate supply left
unaffected.

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Cont…
The analysis of the effect of unanticipated
monetary policy change illustrates an important
difference between the new classical economists
and the original classical theorist. In the new
classical model, economic agents are assumed to
be rational, but they don’t have perfect
information; thus they make mistakes in
predicting the price level and such mistakes
cause short run deviations in output and
employment from their long run equilibrium
rates. In classical system, economic agents were
assumed to have perfect information as a result
there were no deviations from the supply
determined rates of output and employment.
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Cont…
Yet, the new classical view that unanticipated
aggregate demand changes affect output and
employment still does not provide any
meaningful role for use of demand management
policies because the room for the policy makers
to go for such unanticipated policy is very
minimal.

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The New Keynesian School of Thought

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Cont…

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