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CHAPTER ONE: 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.
The issues that macroeconomics addresses include the following:
What determines a nations long-run economic growth? In other words,
why do some nations economies grow quickly, providing their citizens with
rapidly improving living standards, while other nations economies are
relatively stagnant?
What causes a nations economic activity to fluctuate (i. e., rising and
falling)? In other words, why do economies experience sharp short-run
fluctuations staggering between periods of prosperity and periods of
recession (hard times)?
What causes unemployment? That is to say, why does unemployment
sometimes reach very high levels? Why, even during times of relative
prosperity, is a significant fraction of the workforce unemployed?
What causes the price to rise (inflation)? In other words, what causes
inflation to rise sometimes and fall other times and what can be done about
it?
How does being part of a global economic system affect nations
economies? In other words, how do economic links among nations, such as
trade and international borrowing, affect the performance of individual
economies and the world economy as a whole?
Can government policies be used to improve a nations economic
performance? That is to say, if the nations economys output,
unemployment rate, and inflation rate fluctuate, how can government
policies be used to improve the economic performance in order to keep the
nations economy as prosperous and stable as possible?

Macroeconomic Policy
A nations economic performance depends on many factors, including its
natural and human resources, its capital stock (buildings and machines), its
technology, and the economic choices made by its citizens, both individually
and collectively. Another extreme important element affecting economic
performance is the set of macroeconomic policies pursued by the
government.
Although macroeconomic policies affect the economy as a whole, the two
major types of macroeconomic policies are fiscal policy and monetary
policy. Fiscal policy, which is determined at national, state and local levels,
concerns government spending and taxation. Monetary policy determines
the rate growth of the nations money supply and under the control of
government institution known as the central bank (or the Federal Reserve
System in the United States).
Aggregation
Macroeconomics is one of two broad areas within the field of economics, the
other being microeconomics. Macroeconomics and microeconomics have
many basic economic ideas and methods in common; the difference between
them is the level at which the economy is studied. Macroeconomists focus
on individual consumers, workers, and firms, each of which is too small to
have an impact on the national economy. Macroeconomists add consumer
expenditures on all goods and services to get an overall total called
aggregate consumption. The process of summing individual economic
variables to obtain economywide totals is called aggregation. The use of
aggregation and the emphasis on aggregate quantities such as aggregate
consumption, aggregate investment, and aggregate output are the primary
factors that distinguish macroeconomics from microeconomics.
What Macroeconomists Do
How do macroeconomists use their skills, and what do they do with all the
data they gather and the theories they develop? Besides teaching economics,
macroeconomists engage in wide variety of activities, including forecasting,
macroeconomic analysis, basic research, and data development for
government, non-profit organizations, and private businesses.

Macroeconomic Forecasting
Many people believe that economists spend most of their time trying to
forecast the performance of the economy. In fact, forecasting is a minor part
of what macroeconomists do simply because they are not quite good at
forecasting. This is because forecasting is difficult not only because the
macroeconomists understandings of how the economy works is imperfect,
but also because it is impossible to take into account all the factors that
might affect future economic trends. In trying to forecast the course of the
economy, a forecasters find themselves faced with some of the questions
such as how will events abroad (e.g., war in Afghanistan and Iraq) affect
increasing military spending at home, what oil price level will the OPEC
(Organization of Oil Producing and exporting Countries) adopt in its next
meeting, will there be a drought in agricultural regions, with adverse effects
on food prices and quantities. Because answers to such questions are highly
uncertain, macroeconomic forecasters rarely offer a single prediction.
Instead, they usually combine a most likely forecast with optimistic and
pessimistic alternative scenarios.
Do the fact that macroeconomics cant be used to make highly accurate
forecasts of economic activity mean that it is a pointless field of study?
Although some people may think so, that would be unreasonable.
Economists deal with a system whose complexity makes gaining a thorough
understanding difficult and forecasting the system behaviour even more
difficult. Rather than predicting what will happen, most macroeconomists
are engaged in analysing and interpreting events as they happen
(macroeconomic analysis) or in trying to understand the structure of the
economy in general (macroeconomic research).
Macroeconomic Analysis
Macroeconomic analysis is the monitoring of economy and thinking about
the implication of current economic events. Many macroeconomists are
employed in the private sectors such as banks or large corporations. Private
sector analysts try to determine how general economic trends will affect
their employers financial investments, their opportunities for expansion, the
demand for their products, and so on. Some private firms specialize in
macroeconomic analysis and assist their clients on a free-for-service basis.

Public sector, which includes national and regional (state) governments and
international agencies such as the World Bank, and the International
Monetary Fund, also employ many macroeconomic analysts to assist in
policy making. Although the technical advice provided by macroeconomic
analysts is not the only basis on which macroeconomic policy is made, such
advice is necessary for making good policy decision. If a country wants to
make radical reforms in its economy, it is necessary to seek the technical
advice of domestic and foreign economists. The reforms that took place in
the former Soviet Union were led by economists who played an important
role in the debate over restructuring and reforms, both as technical
specialists and as political advocates.
Why Macroeconomists Disagree
The amount of disagreement among the macroeconomists, sometimes
exaggerated by the tendency of the public and the media by focusing on the
most difficult and controversial issues, can be seen by drawing the important
distinction between positive and normative analyses of economic policy. A
positive analysis of an economic policy examines the economic
consequences of a policy but doesnt address the question of whether those
consequences are desirable. A normative analysis of economic policy tries
to determine whether a certain policy should be used. For example, if an
economist is asked to evaluate the effects on the economy of 5% reduction
in the income tax, the response involves a positive analysis. But if asked
whether the income tax should be reduced by 5%, the economists response
requires a normative analysis. This normative analysis will involve not only
the economists objective, scientific understanding of how the economy
works but also personal value judgement for example, about the
appropriate size of government sector or the amount of income redistribution
that is desirable.
Economists may agree on the positive analysis of a question yet disagree on
the normative part because of differences in values. Disagreements usually
occur in economics due to the presence of different schools of thoughts, each
with somewhat different perspective on how the economy works. Examples
include monetarism and supply-side economics. The most important
disagreement on positive issues in macroeconomics involves the two schools
of thought called the classical approach and the Keynesian approach.

Classical Versus Keynesians

The Classical Approach
The origin of the classical approach started at the time of the famous
Scottish economist Adam Smith. In his book entitled The Wealth of
Nations, published in 1776, Smith proposed the concept of the invisible
hand. The idea of the invisible hand is that, if there are free markets and
individuals conduct their economic affairs in their own best interests, the
overall economy will work well. In a market economy individuals, while
pursuing their own self-interests, seem to be led by an invisible hand to
maximize the general welfare of everyone in the economy.
However, it must be stated that invisible hand does not make everyone better
off without making someone else worst off, nor does it rule out the existence
of greater inequalities between the rich and the poor. This is because the
invisible-hand idea assumed the distribution of wealth among people as
given. Instead, the invisible-hand idea says that given a countrys resources
(natural, human and technological) and its initial distribution of wealth, the
use of free market will make people as economically well off as possible.
Whether invisible-hand concept is right or wrong depends on a key
assumption: The various markets in the economy, including financial
markets, labour markets, and markets for goods and services, must function
smoothly and without impediments such as minimum wages and interest rate
ceilings. In particular, wages and prices must adjust rapidly enough to
maintain equilibrium in situation in which the quantity demanded and
supplied are equal in all markets. In market where quantities demanded
exceed quantity supplied, prices must rise to bring the market into
equilibrium. Conversely, in markets where more of good is available than
people want to buy, prices must fall to bring the market into equilibrium.
Wage and price flexibility is important to the invisible-hand idea, because in
a free-market system changes in wages and prices are the signals that
coordinate the actions of people in the economy. The classical approach to
macroeconomics builds on Smiths basic assumption that people pursue their
own economic self-interests and that prices adjust reasonably quickly to
achieve equilibrium in all markets. With these two assumptions as a basis,
followers of the classical approach attempt to construct models of the

macroeconomy that are consistent with the data and that can be used to
answer the questions raised at the beginning of this chapter.
Because classical approach assumptions that the invisible hand works well,
classical economists often argue (as a normative proposition) that the
government should have, at most, a limited role in the economy. As a
positive proposition, classical economists also often argue that government
policies will be ineffective or counterproductive at achieving their stated
goals. Thus, for example, most classical economists believe that the
government should not try actively to eliminate business cycles.
The Keynesian Approach.
The approach that became known as the Keynesian approach was pioneered
by a British economist John Maynard Keynes in a book published in 1936
entitled, The General Theory of Employment, Interest and Money. In that
year, the world was suffering through the Great Depression: Unprecedented
high rates of unemployment had affected most of the worlds economies for
years, and the invisible hand of free markets seemed completely ineffective.
The classical theory appeared to be seriously inconsistent with data, creating
a need for a new macroeconomic theory.
In his book, instead of assuming that wages and prices adjusted rapidly to
achieve equilibrium in each market, Keynes assumed that wages and prices
adjusted slowly. This slow wage and price adjustment meant that markets
could be out of equilibrium with quantities demanded not equal to
quantities supplied for long period of time. According to Keynes,
unemployment can persist because wages and prices dont adjust quickly
enough to equalize the number of people firms want to employ with number
of people who want to work.
Keynes proposed solution to high unemployment was to increase
governments purchase of goods and services, thus raising the demand for
output. According to Keynes, such a policy would reduce unemployment
because, to meet the higher demands for their products, businesses would
have to employ more workers. In addition, Keynes, suggested, the newly
hired workers would have more income to spend, creating another source of
demand for output that would raise employment further. In contrast to the
classicals, Keynesians tend to be sceptical about the invisible hand and thus

are more willing to advocate a role for government in improving

macroeconomic performance.