2.

Introduction to
Macroeconomics
 What Macroeconomics is About

Macroeconomics is the study of the structure and

performance of national economies and of the
policies that governments use to try to affect
economic performance.
Issues Addressed by Macroeconomists

What determines a nation’s long-run

economic growth?
What causes a nation’s economic activity to
fluctuate?
What causes unemployment?
 Issues Addressed by Macroeconomists
(continued)

What causes prices to rise?

How does being a part of a global economic
system affect nations’ economies?
Can government policies be used to improve
economic performance?
(see) The Circular Flow of Income and
Expenditure in an Economy
Descriptive (Positive) Theory
 Macroeconomics
Describes the economy on the highest level of
aggregation
Focus on macroeconomic aggregates, namely
GDP (GNP), consumption, savings, investment,
money, inflation, unemployment, public finance
deficit, current account deficit, public debt,
exchange rate, interest rate and others
Confines the analyses to following five sectors
Sectors on macroeconomic level (1)

Households: all population, own and provide

factors of production (labor, land, capital) to the
firms, receive payments (income) from them and
generate expenditures for goods and services (for
final consumption)

Firms: “own” technology, employ factors,

produce goods and services for final
consumption (households, government, export)
or for intermediate use (other firms, incl. foreign)
 Sectors on macroeconomic level (2)

 Government (state):
 Collects taxes
 Manages activities that society expects from it:
 spends on goods and services for public purpose (e.g.
defence), on employees in state administration, even owns
some firms (that produce goods and services) – “produces”
public services
 finances transfers and social benefits
 Financial sector: provides transmission services that
channel money from savers to borrowers (incl.
government)
 Foreign sector: purchases goods and services
(exports), sells goods and services (imports),
generates flows of capital out and into the domestic
country (FDI in or out, debt financing, equity capital)
 Theory and models

• Formalized relationship among economic

variables (linked to statistical indicators)
– Forms: verbal, graphical, mathematical
• Building blocks:
– Markets and agents

– Focus of the model: endogenous variables

– External environment: exogenous variables

 Structure
• Structure of the model (based on theory):
system of equations (functional forms,
parameters)
• Solution of the system: equilibrium values of
endogenous variables
• Concept of equilibrium: in some
models/theories, equilibrium as a state of the
rest, on some markets supply does not have to
equal demand
• Disturbance to equilibrium: change in
exogenous variables, behavioral and structural
changes (change in parameters or functional
forms) or a random shock
 Time, static and dynamic models
• Static model
– Equilibrium: given exogenous variables, the model
determines endogenous variables in a specific time
moment
– Comparative statics: given the change in exogenous
variable(s), the endogenous variables adjust between two
specific time moments, multipliers
– Time length between the two moments: short, medium or
long term adjustment
• Dynamic (growth) model – determines the development of
endogenous variables in time (growth trajectory)
– Initial conditions
– Assumptions about the time development of exogenous
variables
• Most of our course: static models and comparative statics
Economic policies

Normative Theory
 Towards “the norms” (1)

• Descriptive theory tells us what is, normative

theory tells us what ought to be
• No formalization of normative theories here, but
intuitively, what is “desired”?
– Stable improvement of society’s welfare
– Fair distribution of the welfare among the members of the
society
– In today’s globalized world, convergence of standards of
living in the different regions of the world
– Respect to future generation
• Externalities (like environment)
• Avoid excess; today’s debts being repaid in the future
• Policies, executed by state, as a tool to achieve
the norm (“a desired situation”)
 Potential confusion I
Differentiate: happiness, well-being, welfare,
living standard, economic level
Macroeconomic policies, focused on production
of goods and services (GDP)and employment,
decisively affect only last two terms
 They do significantly affect other three as well, but more as
necessary, but not sufficient condition
 Many other factors do influence people’s happiness and
well-being
 Role of the state

• Different role of the state

• In modern history – 3 approaches how to meet
the norms
Adam Smith
 1723 – 1790
 Political economist
and philosopher
 1751 – professor of
logic at Glasgow
University
 1759 – Theory of Moral
Sentiments
 1776 - An Inquiry in the
Nature and Causes of
the Wealth of Nations
 Laissez faire capitalism

• Free market and political democracy

• Price as basic signal for production decisions
(what, how, for whom)
• Private ownership of means of production
• Small government and minimal governmental
policies/interventions
• Efficient allocation of the resource assumed to
be achieved via market efficiency
Karl Marx
 1818 - 1883
 Philosopher, sociologist,
historian, political economist,
political theorist,
revolutionary socialist
 Communist Manifesto (1848,
with Friedrich Engels)
 Das Kapital (volume I 1869,
volume II and III published
posthumously)
 Ideological founder of
Marxism
 Central planning (socialism)

Consumption decided and resources allocated

through the planning system, not according
price signals
State ownership of productive means
Equal distribution of the wealth
Inconsistency with political democracy, need for
centralized political power
John Maynard Keynes
1883-1946
Cambridge, UK
Thinker – economics,
logic, probability
Practitioner –
Treasury during WWI,
advisor to the War
Cabinet at WWII,
crucial role at the
birth of IMF/WB
 Mixed capitalist economy

Prevailing private ownership, cohabitating with

the state ownership of certain assets
Free market cohabitating with governmental
policies to cope with the deficiencies of the free
market
Welfare state policies.
 General role of the state (1)
State executes different policies/interventions
that affect general welfare of the society
Different groups (with different vested
interests) may have different thoughts about
the role of state here, examples:
 Efficient allocation of the resources ⇒ cultivating the
markets, regulatory and competition policies
 Provision of essential services (e.g. basic education,
defence)
 Attempting to achieve a fair distribution of wealth
across the society ⇒ welfare policies
 Ensuring society’s needs (police, defense, legal
system, coping with the externalities, etc.) ⇒ general
role of state, not a policy
 General role of the state (2)

 Transfer payments, providing minimal living

standards (social policies, e.g. unemployment
benefits)
 Long-term social policies, e.g. securing the stable
health care and pension systems
 Regulation of natural monopolies

 External social costs (e.g. drugs) and benefits (e.g.

free vaccination) of the society
 Support to industry and commerce
 Macroeconomic policies (1)

• Fundamental measure of the economy:

income(output), expressed as gross domestic
product (GDP)
• GDP development over time - GDP growth:
– Over long period: long term growth
• In search of policies that determine the long-term differences
in economic level among the countries
– Over shorter period: business cycle
• In search of policies that help to overcome the fluctuations of
GDP
 Macroeconomic policies (2)
• Other basic economic variables, closely
interlinked with/influencing both short- and long-
term GDP growth
– (un)employment
– inflation
– Interest and exchange rate
– Components of aggregate demand: household
consumption, private investment, expenditure of the state,
exports, imports
– Factors, determining the aggregate supply: amount of
capital and labor available, general productivity of
country’s economy
– Public finance deficit
– Debt of public and private sector (and sum of both)
– Current account deficit and balance of payments
 Macroeconomic policies (3), but …
• When translated into policies, this entails
– Fiscal policy
– Monetary policy
– Exchange rate policy
– International trade policy
• However, since WWII, many other policies emerged
– Supply-side policy
– Price and income policies
– Employment policy
– … and maybe some other policies (according the ideology,
political inclination and maybe populism of policy-makers)
• in this course we almost exclusively cover only the
policies in the first set above
 Some examples (1)

Best illustrated by following examples:

Was the growth difference between 1700-1800
and 1801-2000 result of some organized
„governmental“ activities?
 The power of markets?
 Adam Smith, invisible hand
Was the Great Depression a result of the market
failure?
 Many believe yes (but not all).
 Was an extraordinary growth after WWII a
result of a careful economic policy of the
governments?
 Many macroeconomists 40 years ago convinced that
yes (but in reality, it was not)
 Some examples (2)
Was the state intervention responsible for the
high US inflation in 60s, EU high unemployment
till today or Japanese problems in the 90s?
 Very probably yes.
Was the unexpected outbreak of global financial
and economic crisis after 2007-08 a failure of
macroeconomics as a basis of proper policy
formation?
 Many people believe yes, but some not …