Introduction to Macroeconomics
You can find the .pptx here
Introduction to Macroeconomics
Contents
- #Definition of Macroeconomics
- #The Birth of Macroeconomics
- #Objectives, Variables and Instruments
- #Some Macroeconomic Concepts
- #The AD-AS model
- #The business cycle
- #Micro vs macro
- #Importance / Issues / Scope
- #Limitations / Exceptions
- #Bangladesh examples
- #Glossary
- #Exam questions with model answers
- #Flashcards
- #Recommended Books
- #Self-test questions
Definition of Macroeconomics
- "Macro" comes from the Greek word Macros, meaning larger.
- Macroeconomics looks at the economy as a whole.
- It examines the factors that determine national output and its growth over time.
Definitions by economists
| Economist | Definition |
|---|---|
| R. G. D. Allen | The study of relations between broad economic aggregates such as total employment, income and production. |
| Edward Shapiro | Its major task is explaining what determines the economy's aggregate output of goods and services; it deals with the functioning of the economy as a whole. |
| Augbum | A branch of economics which deals with the economy as a whole. |
| K. E. Boulding | Studies the overall averages and aggregates of the economic system. Not individual incomes but national income; not individual prices but the price level; not individual output but national output. |
Micro = individual income / price / output.
Macro = national income / price level / national output.
The Birth of Macroeconomics
- Every discussion of macroeconomic policy begins with John Maynard Keynes (1st Baron Keynes) (1883–1946).
- Before Keynes, most economists and policy makers accepted the highs and lows of business cycles as inevitable tides.
- Macroeconomics emerged as a distinct branch during the Great Depression of the 1930s, when traditional theories failed to explain widespread unemployment and economic collapse.
- Keynes's key work: The General Theory of Employment, Interest and Money (1936).
Keynes's twofold argument
- High unemployment and underutilized capacity can persist in market economies.
- Government fiscal and monetary policies can affect output, thereby reducing unemployment and shortening economic downturns.
Objectives, Variables and Instruments
Two guiding questions:
- How do economists evaluate an economy's overall performance?
- What tools can governments use to pursue their economic goals?
Objectives vs Instruments
| Objectives | Instruments |
|---|---|
| Output: high level and rapid growth | Monetary policy: control of money supply; affecting interest rates |
| Employment: high employment, low unemployment | Fiscal policy: government expenditure; taxation |
| Price-level stability: stable prices over time |
Macro variables
Macroeconomic variables are the variables that shape macroeconomics. Major ones:
- Aggregate output / production
- Aggregate demand
- Aggregate supply
- National income
- Aggregate savings
- Aggregate consumption
- Aggregate price
- Aggregate investment
- Aggregate expenditure
- Inflation
Tools of macroeconomic policy
A policy instrument is an economic variable under the control of government that can affect one or more macroeconomic goals.
Governments use these tools to reduce inflation and unemployment, speed growth, or correct trade imbalances.
Monetary policy
- The major instrument of macroeconomic policy.
- Conducted through management of the nation's money, credit and banking system.
- By changing the money supply, the central bank influences stock prices, interest rates, housing prices and foreign exchange rates.
Fiscal policy
- The use of taxes and government expenditures.
- Government expenditure has two forms:
- Government purchases of goods and services.
- Transfer payments, which boost the incomes of targeted groups (e.g. the elderly, the unemployed).
- Taxation affects people's disposable (spendable) incomes.
Some Macroeconomic Concepts
Aggregate Demand (AD)
- The total demand for goods and services within a period (usually a year).
- Often viewed as aggregate expenditure: the total money needed to buy all goods and services in a country in that period.
AD = Consumption + Investment + Government expenditure + Net exports
i.e. AD = C + I + G + NX
Components of AD
| Component | Meaning |
|---|---|
| 1. Consumption | Most important component. Determined by disposable income (= personal income − personal tax). |
| 2. Investment | Spending on machinery, factories, software and inventory. Indicators: production level, expenditure on capital, future expectations. |
| 3. Government expenditure | Government purchases of goods and services (e.g. judges' services, arms, tanks, equipment). |
| 4. Net exports | Export income − import expenditure. |
Determinants of AD
| # | Determinant | Effect on AD |
|---|---|---|
| 1 | Rate of interest | Interest ↓ → AD ↑ (and vice versa) |
| 2 | Expectation of profit | Expected profit ↑ → AD ↑ |
| 3 | Foreign exchange rate | Exchange rate of domestic currency ↑ → AD ↑ (as stated on the slides) |
| 4 | Population | Population ↑ → AD ↑ |
| 5 | Aggregate wealth | Wealth ↑ → AD ↑ |
| 6 | Expected inflation | Expected inflation ↑ → AD ↑ |
| 7 | Quantity of money | Money ↑ → AD ↑ |
| 8 | Tax | Tax ↑ → AD ↓ (and vice versa) |
| 9 | Income of other countries | Foreign income ↑ → they buy more from us → AD ↑ |
| 10 | Government expenditure | Gov. spending ↑ → AD ↑ |
| 11 | Transfer payments | Transfers ↑ → AD ↑ |
| 12 | Price level | Price level ↑ → AD ↓ (and vice versa) |
Only interest rate, tax and price level move in the opposite direction to AD. Everything else moves the same direction.
Aggregate Supply (AS)
- The total goods and services all producers of a country are ready to produce at a certain price level in a certain period.
- Directly related to price level: price ↑ → producers produce more → AS ↑; price ↓ → AS ↓.
Determinants of AS
| # | Determinant | Higher / better → | Lower / worse → |
|---|---|---|---|
| 1 | Technology | Improved technology → AS higher | Backward technology → AS lower |
| 2 | Labor | Larger labor force → AS higher | Smaller labor force → AS lower |
| 3 | Infrastructure | Developed → AS higher | Weak → AS lower |
| 4 | Weather | Favorable → AS higher | Unfavorable → AS lower |
| 5 | Capital | Higher capital stock → AS higher | Lower capital → AS lower |
| 6 | Availability of raw materials | Available → AS higher | Scarce → AS lower |
| 7 | Education system | Quality education → better human resources → AS higher | Poor quality → AS lower |
| 8 | Law and order | Peaceful → AS higher | Poor → AS lower |
| 9 | Political stability | Stable → AS higher | Unstable → AS lower |
The AD-AS model
The slides explain aggregate demand and aggregate supply separately. This section shows how they work together.
The economy settles where AD = AS. That point gives the equilibrium price level (P*) and equilibrium real output (Y*).
P ^
|
| AD \ / AS
| \ /
| \ /
| \ /
P*|- - - - -X- - - - - - X = equilibrium
| / \
| / \
| / \
+------------------------> Y (real output)
Y*
- AD slopes downward: price level ↑ → AD ↓ (determinant 12 in the table above).
- AS slopes upward: price level ↑ → producers produce more.
What shifts the curves?
| Event | Curve that shifts | Price level | Real output |
|---|---|---|---|
| Interest rate ↓, tax ↓, government spending ↑, money supply ↑, foreign income ↑ | AD shifts right | ↑ | ↑ |
| The opposite of the above | AD shifts left | ↓ | ↓ |
| Better technology, more labor or capital, better infrastructure, favorable weather, stable politics | AS shifts right | ↓ | ↑ |
| Raw material shortage, unfavorable weather, political instability, poor law and order | AS shifts left | ↑ | ↓ |
A change in the price level causes a movement along a curve. A change in any other determinant causes the whole curve to shift.
The business cycle
The slides say fluctuations are a feature of capitalist economies and that Keynes rejected the idea that they are inevitable. This section names the phases.
| Phase | Output | Employment | Typical policy response |
|---|---|---|---|
| Expansion | Rising | Unemployment falling | Watch for rising prices |
| Peak | Highest point, near full capacity | Very high employment | Contractionary: raise interest rates or taxes to cool inflation |
| Contraction / recession | Falling | Unemployment rising | Expansionary: cut interest rates, raise government spending, cut taxes |
| Trough | Lowest point | Highest unemployment | Expansionary policy continues until recovery |
| Recovery | Starts rising again | Unemployment starts falling | Gradually withdraw support |
- A depression is a very deep, prolonged contraction, like the Great Depression of the 1930s.
- A common textbook rule of thumb: a recession is two or more consecutive quarters of falling real GDP.
- Keynes's argument: fiscal and monetary policy can shorten downturns, so cycles are not simply inevitable tides.
Micro vs macro
| Basis | Microeconomics | Macroeconomics |
|---|---|---|
| Unit of study | Individual consumers, households, firms and single markets | The economy as a whole (aggregates) |
| Central question | How are the price and output of a particular good determined? | What determines national output, employment and the price level? |
| Key variables | Price of a good, individual income, a firm's output, demand and supply of one product | National income, aggregate demand and supply, general price level, inflation, unemployment |
| Main concern | Resource allocation and efficiency | Growth, full employment and price stability |
| Policy tools | Specific taxes, subsidies, price controls | Monetary policy and fiscal policy |
| Origin | Older classical and neoclassical tradition | Distinct branch from the 1930s (Keynes) |
| Example question | Why did the price of rice rise? | Why did overall inflation rise? |
Paradox of thrift: one household that saves more becomes better off. If everyone saves more, spending falls, aggregate demand falls, incomes fall, and total saving may not rise. What is true for the part is false for the whole.
The two are linked, as the slides say: macro results rest on the behavior of many individual units, and micro analysis needs the aggregate setting.
Importance / Issues / Scope
- Functioning of an economy: helps explain how a complex modern economy works, and how national income and employment are determined by aggregate demand and aggregate supply.
- Formulation of economic policies:
- The days of laissez-faire are over; government intervention is an accomplished fact.
- Governments deal with groups and masses, not individuals.
- Example: in a depression (idle machines, jobless people), macroeconomics helps analyze the causes and choose suitable policies.
- Understanding microeconomics:
- No macroeconomic law can be framed without first studying aggregates.
- A theory of the firm needs the behavior of several firms, not one.
- Analogy: a forest is an aggregation of trees but doesn't show the behavior of individual trees.
- Microeconomics remains "a jungle of special assumptions, special cases, unsatisfactory measurements and abstract theorizing".
- Understanding and controlling economic fluctuations:
- Fluctuations are characteristic of capitalist societies.
- Studying them requires aggregate consumption, saving and investment.
- Helps analyze causes of fluctuations in income, output and employment and reduce their severity.
- Inflation and deflation: different sections of society are affected differently by changes in the value of money; macro analysis helps counteract the adverse effects.
- Study of national income:
- Brought out the importance of national income and social accounts.
- Key indicator of a country's whole economy.
- Revealed that three-fourths of the world lives in abject poverty (per the slides).
- Correct economic policies are not possible without it.
- Study of economic development: draws attention to underdeveloped countries, and reveals inequalities of wealth within economies and differences in living standards between countries.
- Performance of an economy:
- Result-oriented study of actual achievements.
- GNP / National Income estimates compare production across periods.
- The composition of GNP shows each sector's contribution.
- Nature of material welfare:
- Studies the nature and size of nations' material welfare.
- Measuring social welfare is hard; even welfare economics doesn't fully help.
- When the aim of economics is the welfare of the whole society, economics becomes macroeconomics.
- Balance of payments: explains its determinants, identifies the causes of deficits and suggests remedies.
- Solving economic problems: poverty, unemployment, business cycles, etc., can be solved only at the level of the whole economy.
Limitations / Exceptions
- Ignores individual welfare. Example: raising national saving at the cost of individual welfare is not considered a wise policy.
- Fallacy of composition: propositions true for individuals or small groups often turn out false for the whole economy.
- Treats aggregates as homogeneous and ignores their internal composition. Example: if clerks' wages fall and teachers' wages rise, the average wage can stay the same.
- Not all aggregate variables are equally important. Example: national income can rise just because a few rich families earned more, without individual incomes rising generally.
- Models mostly reflect developed countries. Developing countries face different realities and benefit less from them.
Bangladesh examples
These link the theory to the Bangladesh economy in general terms. I left out numbers on purpose. Use current data from Bangladesh Bank, the Bangladesh Bureau of Statistics or your course material before quoting figures in an exam or assignment.
| Concept | Bangladesh illustration |
|---|---|
| Monetary policy | Bangladesh Bank, the central bank, manages money, credit and banking. It uses its policy rate and other tools to influence interest rates and credit, and announces its stance in its Monetary Policy Statement. |
| Fiscal policy | The national budget is presented each year for the fiscal year starting 1 July. It sets taxes (income tax, VAT, customs duties) and government spending. |
| Transfer payments | Social safety net programs such as old-age and widow allowances and student stipends raise the incomes of targeted groups. |
| Consumption | Remittances from workers abroad raise household disposable income, which supports consumption and aggregate demand. |
| Net exports | Ready-made garments dominate exports, while fuel, capital machinery and some food items are major imports. |
| Exchange rate | If the taka depreciates, exports become cheaper abroad and imports dearer, so net exports tend to rise (AD ↑). But costlier imported inputs raise production costs (AS ↓). |
| Population | A large population supports aggregate demand. |
| AS: infrastructure | Power and gas supply, ports and roads strongly affect how much firms can produce. |
| AS: weather | Floods and cyclones can damage agriculture and cut supply. |
| AS: law and order and political stability | Strikes, blockades and unrest disrupt production and transport. |
| AS: labor and education | A large young workforce raises potential supply, but skills and education quality decide how much it adds. |
| Inflation | Rising food and fuel prices hit households unevenly, which is the slides' point about inflation affecting different sections of society differently. |
| Limitation 4 | Higher national income or GDP does not show whether the gains are spread evenly. Income distribution can hide behind the average. |
| Limitation 5 | A large informal sector and the weight of agriculture and remittances mean models built for developed economies fit only partly. |
Glossary
| Term | Meaning |
|---|---|
| Aggregate | A total for the whole economy, such as total output or total consumption |
| GDP (Gross Domestic Product) | Value of final goods and services produced within a country in a period |
| GNP (Gross National Product) | GDP plus net income earned from abroad; measures output by a country's residents |
| National income | Total income earned by a country's residents in a period |
| Real vs nominal | Nominal uses current prices; real is adjusted for inflation |
| Disposable income | Personal income minus personal tax |
| Transfer payment | Government payment with no good or service in return, such as an allowance or pension |
| Net exports | Export income minus import expenditure |
| Investment | Spending on machinery, factories, software and inventory (not buying shares) |
| Laissez-faire | The view that government should not intervene in the economy |
| Inflation | A sustained rise in the general price level |
| Deflation | A sustained fall in the general price level |
| Stagflation | High inflation together with high unemployment and weak growth |
| Business cycle | Recurring ups and downs in output and employment |
| Recession | A significant fall in output; often defined as two consecutive quarters of falling real GDP |
| Depression | A very severe and prolonged recession |
| Monetary policy | Control of money supply and interest rates by the central bank |
| Fiscal policy | Use of government spending and taxation |
| Central bank | The institution that manages the money supply and banking system (Bangladesh Bank in Bangladesh) |
| Balance of payments | Record of all a country's economic transactions with the rest of the world |
| Full employment | Everyone who wants a job at the going wage can find one |
| Policy instrument | A variable the government controls that can affect macro goals |
Exam questions with model answers
Answers are built from the lecture content. Expand each point with an example in the exam.
Definition: "Macro" comes from the Greek Macros (larger). It studies the economy as a whole: national output, income, employment and the price level. Allen calls it the study of relations between broad aggregates; Boulding says it deals with national income, not individual incomes, the price level, not individual prices, and national output, not individual output.
Difference: micro studies individual units such as a consumer, a firm or one market. Macro studies totals such as GDP, aggregate demand and inflation. (See the #Micro vs macro table.)
- Explains how the whole economy functions and how income and employment are determined.
- Guides economic policy now that laissez-faire is over.
- Helps understand microeconomics, since aggregates come first.
- Helps understand and control economic fluctuations.
- Helps analyze inflation and deflation.
- National income study shows the state of the economy and the extent of poverty.
- Draws attention to development and inequality between countries.
- Measures the performance of the economy (GNP, national income).
- Helps study material welfare.
- Explains balance of payments problems and remedies.
- Helps solve problems such as poverty, unemployment and business cycles that only make sense at the economy level.
Before Keynes, economists accepted business cycles as inevitable. The Great Depression of the 1930s exposed the failure of traditional theory to explain mass unemployment. In The General Theory of Employment, Interest and Money (1936), Keynes argued (1) high unemployment and idle capacity can persist in market economies, and (2) government fiscal and monetary policy can raise output, reduce unemployment and shorten downturns.
Objectives: high and rapid output growth; high employment and low unemployment; stable price level.
Instruments: monetary policy (control of money supply, influence on interest rates, through the central bank) and fiscal policy (government expenditure, which includes purchases and transfer payments, and taxation, which changes disposable income).
Aggregate demand is the total desired expenditure on goods and services in an economy in a year: AD = C + I + G + NX.
Components: consumption (driven by disposable income), investment, government purchases, net exports.
Determinants: interest rate, expected profit, exchange rate, population, wealth, expected inflation, money supply, taxes, foreign income, government spending, transfer payments, price level. Interest rate, tax and price level have an inverse relationship with AD; the others are direct. (See the #Some Macroeconomic Concepts table.)
Aggregate supply is the total goods and services producers are willing to produce at a given price level in a period. It rises with the price level.
Determinants: technology, labor, infrastructure, weather, capital, raw materials, education, law and order, political stability. Better conditions raise AS; worse conditions lower it.
- Ignores individual welfare.
- What is true for individuals may be false for the whole economy (fallacy of composition, e.g. paradox of thrift).
- Treats aggregates as homogeneous and hides their internal composition (clerks' wages fall, teachers' rise, average unchanged).
- Not all aggregates are equally important; rising national income may reflect gains for a few rich families.
- Models are built for developed countries and fit developing countries less well.
Monetary policy is run by the central bank through the money supply, credit and interest rates. Fiscal policy is run by the government through taxes and spending (purchases and transfers). Monetary policy mainly works through financial variables; fiscal policy works directly through incomes and spending.
Flashcards
Format for the Obsidian Spaced Repetition plugin answer on one line. Set the plugin's flashcard tag to #flashcards, or change the tag below.
What does "macro" mean?::From the Greek Macros, meaning larger
Macroeconomics studies what?::The economy as a whole: national output, income, employment, price level
Who defined macro as the study of relations between broad aggregates (total employment, income, production)?::R. G. D. Allen
Whose definition says "national income, not individual incomes; price level, not individual prices"?::K. E. Boulding
Who is the economist most associated with the birth of macroeconomics?::John Maynard Keynes (1883–1946)
Which event led macroeconomics to emerge as a distinct branch?::The Great Depression of the 1930s
What is Keynes's 1936 book?::The General Theory of Employment, Interest and Money
Keynes's two arguments?::(1) High unemployment and idle capacity can persist; (2) fiscal and monetary policy can raise output and cut unemployment
Three objectives of macro policy?::High output growth, high employment, price-level stability
Two instruments of macro policy?::Monetary policy and fiscal policy
Major instrument of macro policy?::Monetary policy
What is a policy instrument?::An economic variable under government control that can affect macro goals
Two forms of government expenditure?::Purchases of goods and services, and transfer payments
Fiscal policy means?::Use of taxes and government expenditure
Aggregate demand formula?::AD = C + I + G + NX
Disposable income =?::Personal income − personal tax
Net exports =?::Export income − import expenditure
Which AD determinants move opposite to AD?::Interest rate, tax, price level
What happens to AD if the interest rate falls?::AD rises
Aggregate supply is related to the price level how?::Directly: price level up, AS up
Name the 9 determinants of AS::Technology, labor, infrastructure, weather, capital, raw materials, education, law and order, political stability
Common name for what is true of parts but false of the whole?::Fallacy of composition (e.g. paradox of thrift)
Why do average wages hide information?::They ignore internal composition: clerks' wages can fall while teachers' rise, leaving the average unchanged
Why are macro models less useful for developing countries?::They are mostly built to approximate developed economies
GNP vs GDP?::GNP = GDP + net income from abroad
What is stagflation?::High inflation together with high unemployment and weak growth
A change in price level causes what on the AD or AS graph?::A movement along the curve; other determinants shift the curve
Recommended Books
- P. A. Samuelson: Economics
- K. K. Dewett: Modern Economic Theory
- Shapiro, E. (2003): Macroeconomic Analysis
- Hall and Taylor: Macro Economics
- Baumol and Blinder: Economics: Principles and Policy
- H. L. Ahuja: Modern Economics Theory
- E. K. Browning and J. M. Browning: Microeconomics Theory and Applications