1 An Introduction to Macroeconomics

After studying this topic, you should be able to understand

· Economics studies as to how the society can allocate its limited resources most efficiently.

· The field of economics has been divided into distinct areas of study: microeconomics and macroeconomics.

· With the advent of Keynes’ book, The General Theory of Employment, Interest and Money in the year 1936 began the Keynesian era. It was followed by the development of the supply side economics.

· Whether it is an individual, consumer, firm, or government, macroeconomics is important for all.

· The variables in any economic model can be a stock or a flow.

· A static relationship exists when all variables relate to the same time period and a dynamic relationship exists when all the variables relate to different time periods.

· A given set of relationships between the variables may lead to an equilibrium or a disequilibrium solution. MACROECONOMICS AND MICROECONOMICS

The word economy is believed to have been derived from a certain Greek word which means a person who manages a household. A household has to make many decisions. Similar to a household, a society is also involved in making many decisions. A society also faces the same problem of limited resources (which include capital, labour force, natural resources, entrepreneurship, and technology) and unlimited wants like a household.

Since all our resources are limited in comparison to our wants and needs, both individuals and nations will have to make decisions as to the goods and services they can purchase and the ones they have to forgo.

So due to the problem of scarcity, individuals and economies have to make decisions in the allocation of their resources. Economics seeks to study as to why we make these decisions and how we can allocate our resources most efficiently.

The field of economics has been divided into two distinct areas of study: microeconomics and macroeconomics.

Microeconomics is that branch of economics which analyses the market behaviour and decision-making process of the individual consumers and firms.

Macroeconomics, on the other hand, is the study of how the national economy as a whole grows and the changes that occur over time. Thus, it analyses the big or the macro picture. Hence, the basic concerns of macroeconomics are to measure as to how well an economy performs, works, and then try to improve the performance of the economy. Macroeconomics is very complicated and influenced by many factors. These factors can be analysed through various economic indicators that tell us about the overall health of an economy. Thus, macroeconomics deals with big issues like price stability or inflation and full employment or unemployment.

BOX 1.1

On 23 October 1929, the Wall Street (which is the New York Stock Exchange) crashed. This was no ordinary crash. This financial catastrophe crippled not only the US economy but also affected the rest of the world. Successful people became paupers overnight leading to an increase in the suicide rates. For the world, the years ahead seemed to be the most financially difficult years possible. Before the crash, unemployment was about 3 per cent in US, while by 1933 it had increased to a quarter of the US labour force who found themselves unemployed. The high level of unemployment resulted in a fall in demand since the public did not have any money to spend. This lowered the prices of the goods. The agriculture, basic consumer goods industries, and others were affected badly. This heralded what is termed as the Great Depression, only Germany appeared to be sailing on safe water, which emerged as one of the most powerful nations economically.

Micro- and macroeconomics are both intertwined. By improving their knowledge of certain phenomena, economists can help individuals and nations in making more efficient decisions in allocating the resources. It is important to note that what microeconomics considers as given, the total output, total employment, and total expenditure on the goods and services, macroeconomics takes it as one of its most important variables. On the other hand what macroeconomics takes as given, the distribution of the total output, total employment, and total expenditure among the goods and services of the different firms and the different industries, microeconomics takes it as a variable to be determined.

Although a distinction has often been made between microeconomics and macroeconomics, strictly speaking there is only one ‘economics’. While the foundation of microeconomics lies in macroeconomics, the foundation of macroeconomics lies in microeconomics. Thus, an analysis of an economy cannot be conducted in two separate watertight compartments of macroeconomics and microeconomics.

RECAP

· Microeconomics analyses the market behaviour and decision-making process of the individual consumers and firms.

· Macroeconomics is the study of how the national economy as a whole grows and changes, which occur over time. BACKGROUND OF MACROECONOMICS

The founder of the field of microeconomics is thought to be Adam Smith. As already discussed, it is that branch of economics, which is concerned with the behaviour of individual entities like firms, households and markets. These are the issues that Adam Smith has addressed in his book The Wealth of Nations.

Macroeconomics, the other major branch of economics, is of relatively recent origin as compared to microeconomics. However, it did exist earlier also but not with the same popularity that it gained with Keynes. One can trace the origin of macroeconomics by dividing it into three stages:

Classical School of Thought: Karl Marx was responsible for the origin of the term ‘classical’. He used this term to include the theories of David Ricardo, James Mill, and the other economists who preceded him. Later on, Keynes extended the term classical to include the followers of Ricardo including Marshall, J. S. Mill, Pigou and Edgeworth.

The Keynesian Economics: In the 1930s, the most dramatic developments took place. The US economy, even with a quarter of its resources lying idle (a less than full employment situation), plunged into a depression. The classical school failed to provide any explanation to this turn of events.

The answer to the problems that the US economy faced came in the form of Keynes’ book, The General Theory of Employment, Interest and Money in the year 1936. The book provided a theory to explain the events, which plagued the US economy at that particular time. The book with its embedded theories was well received and began the Keynesian era.

The response of the classical school to the situation was the argument that full employment was the normal situation in any economy. However, departures in the form of less than full employment could temporarily occur. But the automatic forces present in a competitive market would push the economy back to the full employment equilibrium. The experiences of the US economy with the relatively few but temporary depressions in the early twentieth century lend credence to these views. Their basic tenet was that it was not possible for aggregate demand for goods and services to fall short of aggregate supply except for a temporary period.

Keynes’ general theory was an alternative theory that explained the determination of employment and output, and also the explanation as to why the market forces in an economy would not automatically generate a level of aggregate demand which was required for full employment.

Keynes’ theory was followed by refinements, termed as Keynesian economics, which were later applied to tackle the analysis of inflation during and after World War II. With its growing success in providing a solution to the major macroeconomic issues, the Keynesian theory held sway into the 1960s.

The success faced by the US economy was, however, short lived. The various restrictive policy measures, recommended by the Keynesian theory, were not successful in checking the inflation and, in fact, responsible for pushing the US economy towards a recession in 1970, which was later followed by double digit rate of inflation that gripped the US economy. In such a situation, Keynesian economics, where the tools were designed for the specific purpose of controlling aggregate demand, could not provide a solution to the problem of controlling inflation and a recession, simultaneously. What were required were tools to manage the long neglected supply side. This was followed by the development of what is called the supply side economics.

The Post-Keynesian Economics: Notwithstanding the tremendous success which Keynes and his book received, it could not in any way prevent the further developments that occurred on the classical front to appear under the heading of neo-classical, especially during the 1950s.

Starting in the 1950s and continuing till today is the development of another extension of the classical theory, which assigns a very critical role to money as a major factor in determining whatever happens in an economy.

In the 1970s, the classical theory took a new turn with the introduction of the concept of rational expectations. This was the latest theoretical development on the classical front whose roots were firmly embedded in the classical theory. The emphasis here was on the role played by the individual’s rational expectations regarding future economic events. Later on, there appeared the supply side economists with their emphasis on the factors operating on the supply side.

BOX 1.2

It was the Keynesian macroeconomics and the implementation of the proper plans and in the right directions which were responsible, to some extent, in building up the US economy in the aftermath of the Great Depression. Today, most of the economies in Africa and even in parts of South America are facing struggle, which is worse than what the US faced at the time of the Great Depression. Faced with the problems of poverty, issues of health and education, these economies are in a dire need of economic policies, which can help them in coming out of such doldrums. However, these policies can be determined only after a thorough study of the macroeconomic issues, which affect these economies.

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· The answer to the problems in the US economy came in the form of Keynes’ book.

· In the 1960s and 1970s, the theory that gained popularity is known as monetarism. NEED TO STUDY MACROECONOMICS

From the viewpoint of an individual: Macroeconomics may exercise a strong influence on the individual investor. For understanding and analysing the long-term trends and also the aggregate market behaviour, the principles of macroeconomics play a very important role. Thus for an individual who is managing his own asset portfolio, it may be of considerable importance to be aware of the current fiscal policy and also as to what will be its repercussions on the value of the government bond holdings. Depending on the objectives of the fiscal policy, the government may buy back the bonds or it may issue more bonds.

From the viewpoint of the consumers, firms and governments: The macroeconomists try to anticipate the economic conditions to be able to help the consumers, the firms and the governments in making their decisions.

The consumers’ interest lies in knowing how easy or difficult it will be for them to be able to find work. They are also concerned about the price of the goods and service and also as to how much may be the cost of borrowing.

The interest of the business lies in knowing whether or not to expand production. They are also concerned about whether the consumer will have sufficient purchasing power to buy the product.

The government is concerned with the macroeconomy when planning its budget and taxes, deciding on the interest rates and making its other policy decisions in national interest.

From the viewpoint of an economy’s performance: An economy’s performance is of considerable importance to all of us. We evaluate the performance of the macroeconomy by essentially looking at the national output, the rate of unemployment, the inflation rate and the trade performance. Even though it is the consumers who play the most important role in determining the direction that an economy traverses, the government also plays its role through the fiscal and monetary policy. A study of macroeconomics helps us to evaluate the success or failure of the economic policies of the government and the Central Bank of the country.

From the viewpoint of an economy’s stability and growth: Although macroeconomics involves a wide field of study, there are two areas which are typical of the discipline:

The business cycle: Macroeconomists are involved in trying to analyse the short-run fluctuations in the national income that lead to the business cycles.

Increase in the national income: The determinants of long-run economic growth are of great interest to the macroeconomists, which are responsible for the increase in the national income.

Both the government and the corporations utilize the macroeconomic models and their forecasts to foster the process of development, and also in the evaluation of economic policies and the business strategies. This would help in maintaining stability and attaining growth.

In the present scenario with the world in the grips of recession, macroeconomists are busy in trying to diagnose the cause of the recession and to find the policies or the mix of policies that will help the different economies of the world to pull out of the recession.

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· Macroeconomics helps to evaluate the performance of the economy, in terms of the national output, the rate of unemployment, the inflation rate and the trade performance. CONCEPTS IN MACROECONOMICS

The variables in any economic model can be a stock and/or a flow. A relationship is postulated among these variables in the model. If all the variables in the model relate to the same time period, then it is a static relationship, while if the variables relate to different time periods it is a dynamic relationship. A given set of relationships between the variables may lead to an equilibrium or a disequilibrium solution. An equilibrium solution can be analysed through a static methodology, whereas a disequilibrium solution can be analysed through a dynamic methodology. If the model pertains to a situation where one equilibrium position is succeeded by another equilibrium position, then it can be analysed through comparative statics. Stocks and Flows

Both stocks and flows are variables. Both are quantities that may increase or decrease over time. However, there is a difference between them, stock is a quantity measured at a point in time wheeras flow is a quantity measured over a period of time.

Stock is a quantity, which is measured at a point in time.

Some macro stock variables are the money supply, the total number of people employed in an economy, the total stock of capital, the total labour force, etc. Some macro flow variables are the savings, investment, change in inventories, change in the money supply, etc.

Flow is a quantity measured over a period of time.

It is important to note that often stock and flow are related. This is because a flow is actually the change in the stock. For example, while the total number of people employed in an economy is a stock variable, the numbers of people who take up new jobs or leave jobs are flow variables. While money is a stock variable, the expenditures in money or the spending of money is a flow variable. While inventories is a stock variable, the change in inventories is a flow variable.

It is not necessary that there should be a flow counterpart to every stock variable. Imports and exports, taxes, wages and salaries, and dividends are flows. There is no direct stock counterpart to them. However, though they do not have a stock counterpart, it is important to note that they do influence the other stock variables. For example, imports may affect the size of the stock of capital and also the stock of inventories, while wages and salaries may have an effect on the stock of housing.

For the flow variables where a direct stock counterpart exists, any change in the amount of the stock between two specific points of time will depend on the changes in the flow variables between those specific points of time. For example, the change in an economy’s capital stock between two specific points in time depends on additions to the stock of capital and the consumption of capital goods.

While a change in stock occurs due to a change in the flow, a change in flow may also be influenced by a change in the stock. For example, a change in inventories is brought about by many factors including a change in the stock of capital. An excessive stock of capital may necessitate a decrease in the flow of investment and may thus be responsible for a business going downhill. However, it is important to note that stock can influence flows only in long run. Equilibrium and Disequilibrium

In the simplest terms, equilibrium is a state of balance or a state where there is no change. The forces acting in the system may bring about a change in the economy. However, the net effect of the change is that the equilibrium position does not, in any way, get disturbed. On the other hand, disequilibrium is a state of imbalance.

The macroeconomic model, which can be considered here, is related to aggregate demand and aggregate supply as shown in Figure 1.1.

Equilibrium is a state of balance or a state where there is no change.

Figure 1.1 Aggregate Demand and Aggregate Supply

Here,

The aggregate demand, AD, curve relates to the aggregate quantity of all the goods and services demanded or in the other words it is the summation of the spending by the individuals, businesses, government and the net exports at each price level. The aggregate supply, AS, is the amount produced and supplied by the business at each price level. An equilibrium is determined at the intersection of the aggregate demand and aggregate supply curves at point E with the equilibrium output at Y* and the equilibrium price at P*. Thus at P*, the aggregate quantity of the goods and services demanded and supplied is equal.

Disequilibrium will exist at any price higher or lower than P*. At a price higher than P*, the aggregate quantity of the goods and services demanded will be less than the aggregate quantity supplied and, therefore, the price level will fall until equilibrium is achieved. At a price lower than P*, the aggregate quantity of the goods and services demanded will be more than the aggregate quantity supplied and, therefore, the price level will rise until equilibrium is achieved.

Flow equilibrium can be taken as the short-run equilibrium, while a stock equilibrium can be taken as the long-run equilibrium. It is necessary to remember that a stock equilibrium cannot exist without flow equilibrium because long-run equilibrium cannot exist without short-run equilibrium.

The concept of equilibrium is of utmost importance, it identifies that position where the variables are in a balanced state. Disequilibrium is again of importance, as it is more close to economic reality than equilibrium. The Keynesian model is, in fact, built upon the disequilibrium analysis. Statics, Dynamics and Comparative Statics

We have already focused on the stock and flow variables found in the economic models. Equilibrium and disequilibrium are the two positions that these models are in at any point in time. Two methods employed in the construction of these economic models are statics and dynamics.

In static models, the relations between different variables relate to the same period in time. There is no need to be concerned about the problem of dating. Thus, static models are not able to trace the changes in the values of different variables over time. Hence, these models are unable to explain the process of change. They apply to models which are in a state of equilibrium.

Static models are those where the relationship between the different variables relates to the same period in time.

A special case of a static model is what is called a stationary equilibrium. Here, there are no changes and the same equilibrium position is repeated from one period to another.

Dynamic models trace the changes that occur in the values of the different variables over time. They apply to models that are in a state of disequilibrium. Disequilibrium is a state where there are changes in the values of the variables over time. To analyse a model that is in a state of disequilibrium, dynamics is used. Hence, dynamics traces the changes in the values of the variables as they move through the different disequilibria to arrive at the position of equilibrium.

Dynamic models are the models that trace the changes that occur in the values of the different variables over time.

Comparative Statics: While static models relate to a study of the equilibrium at a particular point of time, comparative statics compares two or more such equilibrium states. Comparative statics can be used to analyse, for example, the changes in an equilibrium price and quantity brought about by the shifts in the demand and/or supply curves. However, it is important to note that the process or the path through which one equilibrium position moves to another equilibrium position is not analysed under the domain of comparative statics, which is discussed under dynamics. Comparative statics performs the task of bridging the gap between the two equilibrium positions, but is unable to explain the path which has been traversed.

Comparative statics is of relevance only when an old equilibrium is succeeded by a new equilibrium position. When the old equilibrium is succeeded by a new disequilibrium position, comparative statics is not relevant. Partial Equilibrium and General Equilibrium

Economists often distinguish between partial and general equilibrium analyses.

In a partial equilibrium analysis, which is the basis of study in microeconomics, more factors are assumed to be held constant as compared to a general equilibrium analysis. Hence, only a small number of variables are allowed to change while all the other variables are assumed to be constant.

Partial equilibrium approach involves the determination of the equilibrium price and output in each market, ceteris paribus.

A partial equilibrium analysis is based on the assumption of ceteris paribus, that is, we assume everything other than the market we are analysing, to be constant. For example, in an analysis of the maximization of the utility of the consumer we assume that his income is constant. In analysing the demand for say commodity X, we assume all factors, other than the price of commodity X including income, tastes and price of other commodities to be constant. In the product market, the interaction of the buyers and sellers determines the equilibrium price and output, ceteris paribus or in other words ignoring the relationship with the other markets. Thus, a partial equilibrium approach involves the determination of the equilibrium price and output in each market, ceteris paribus.

The main problem with a partial equilibrium approach is that it ignores the interdependence and the linkages between the different markets. For example, in analysing the demand for say commodity X, we assume all factors other than the price of commodity X including income, tastes, and price of other commodities to be constant. However in reality, the demand for commodity X depends not only on the price of commodity X but also on the individual’s income, his tastes and the price of the other commodities, which may be substitutes or complements to the commodity.

General equilibrium analysis involves a state where all the markets and the decision-making units in the economy are in a simultaneous equilibrium. Hence, it studies the simultaneous equilibria in a group of interrelated markets emphasizing the interdependence between the different economic units in the economy.

General equilibrium approach involves a state where all the markets and the decision-making units in the economy are in a simultaneous equilibrium.

A general equilibrium approach analyses an economy in its totality taking into consideration the linkages between the different sectors in the economy. It does not consider the restrictive assumptions used in the partial equilibrium analysis. As compared to a partial equilibrium analysis, it allows many more variables to change.

While Marshall’s name is associated with partial equilibrium analysis, general equilibrium analysis is associated with the French economist Leon Walras. He analysed an economic system where the firms were perfectly competitive and the consumers were utility maximizers. The model showed that under such conditions, a unique stable equilibrium can exist. However, economists have raised doubts about the stability and the uniqueness of such equilibrium.

In the modern world economics, while Marshall’s partial equilibrium analysis is said to be relevant for the learners as well as the non-interventionist arts academicians, real economists are more interested in Walras’s general equilibrium analysis.

RECAP

· A stock is measured at a point in time, while flow is measured over a period of time.

· Equilibrium is a state of balance where there is no change.

· In static models, the relations between different variables relate to the same period in time.

· General equilibrium is a state where all the markets and the decision-making units in the economy are in a simultaneous equilibrium.

SUMMARY MACROECONOMICS AND MICROECONOMICS

Like a household, a society also faces the problem of limited resources and unlimited wants.

Due to the problem of scarcity, individuals and economies have to make decisions for the allocation of their resources.

The field of economics has been divided into two distinct areas of study: microeconomics and macroeconomics, which are both intertwined.

Microeconomics is that branch of economics, which analyses the market behaviour and decision-making process of the individual consumers and firms.

Macroeconomics, on the other hand, is the study of how the national economy as a whole grows and the changes that occur over time. BACKGROUND OF MACROECONOMICS

The founder of the field of microeconomics is thought to be Adam Smith.

Macroeconomics, the other major branch of economics, is of relatively recent origin as compared to microeconomics. One can trace the origin of macroeconomics by dividing it into three stages.

1. The classical school of thought includes the theories of David Ricardo, James Mill, Marshall, J. S. Mill, Pigou and Edgeworth.

2. The Keynesian economics provided an alternative theory to explain the determination of employment and output.

3. The post-Keynesian economics, the monetarism, assigns a critical role to money.

In the 1970s, the classical theory took a new turn with the introduction of the concept of rational expectations. NEED TO STUDY MACROECONOMICS

From the viewpoint of an individual, macroeconomics may exercise a strong influence on the individual investor. For an individual who is managing his own asset portfolio, it may be of considerable importance to be aware of the current fiscal policy.

From the viewpoint of the consumers, firms, and governments, macroeconomics is again important. The consumer’s interest lies in knowing how easy or difficult it will be for them to be able to find work, about the price of the goods and service and also as to how much may be the cost of borrowing. The interest of the business lies in knowing whether or not to expand the production. The government turns to macroeconomics when planning its budget and taxes, deciding on the interest rates and making its other policy decisions.

From the viewpoint of an economy, its performance is evaluated by the national output, the rate of unemployment, the inflation rate, and the trade performance.

From the viewpoint of an economy’s stability and growth, macroeconomists are involved in trying to analyse the short-run fluctuations in the national income, which lead to the business cycles. CONCEPTS IN MACROECONOMICS

Stock is a quantity which is measured at a point in time, whereas flow is a quantity measured over a period of time.

A change in stock occurs due to a change in the flow, whereas a change in flow may also be influenced by a change in stock.

Equilibrium is a state of balance or a state where there is no change. On the other hand, disequilibrium is a state of imbalance.

Flow equilibrium can be taken as short-run equilibrium, whereas a stock equilibrium can be taken as long-run equilibrium.

Two methods employed in the construction of these economic models are statics and dynamics.

In static models, the relations between the different variables relate to the same period in time. Hence, these models are unable to explain the process of change.

A special case of a static model is what is called a stationary equilibrium where there are no changes and the same equilibrium position is repeated from one period to another.

Dynamic models trace the changes that occur in the values of the different variables over time. PARTIAL EQUILIBRIUM AND GENERAL EQUILIBRIUM

Economists often distinguish between partial and general equilibrium analysis.

A partial equilibrium analysis is based on the assumption of ceteris paribus, that is, we assume everything other than the market we are analysing to be constant.

General equilibrium analysis involves a state where all the markets and the decision-making units in the economy are in a simultaneous equilibrium.

Marshall’s name is associated with partial equilibrium analysis. On the other hand, general equilibrium analysis is associated with the French economist Leon Walras.

In the modern world of the twentieth century economics, Marshall’s partial equilibrium analysis is said to be relevant for the learners as well as the non-interventionist arts professors, real economists are more interested in Walras’s general equilibrium analysis.

REVIEW QUESTIONS TRUE OR FALSE QUESTIONS

Macroeconomics is that branch of economics, which analyses the market behaviour and decision-making process of the individual consumers and firms.

Flow is a quantity which is measured at a point in time, whereas stock is a quantity measured over a period of time.

Static models are those models that trace the changes that occur in the values of the different variables over time.

General equilibrium approach involves a state where all the markets and the decision-making units in the economy are in a simultaneous equilibrium.

Marshall’s name is associated with general equilibrium analysis. On the other hand, partial equilibrium analysis is associated with the French economist Leon Walras. VERY SHORT-ANSWER QUESTIONS

What is microeconomics?

What is macroeconomics?

Write a short note on the classical school of thought?

How important is macroeconomics from the viewpoint of an economy’s performance?

Differentiate between a stock and a flow. SHORT-ANSWER QUESTIONS

Differentiate between microeconomics and macroeconomics.

Discuss the need for macroeconomics from the viewpoint of the consumers, firms, and governments.

Distinguish between static and dynamic models.

What is comparative statics? How is it different from statics?

Differentiate between a partial equilibrium approach and a general equilibrium approach. LONG-ANSWER QUESTIONS

Trace the origin of macroeconomics through its three stages.

Write a short note on the Keynesian economics.

What is the relationship between a stock and a flow? Explain with examples.

Write a short note on equilibrium and disequilibrium.

Write a short note on statics, dynamics and comparative statics.

ANSWERS TRUE OR FALSE QUESTIONS

False. Microeconomics is that branch of economics which analyses the market behaviour and decision-making process of the individual consumers and firms.

False. Stock is a quantity which is measured at a point in time, while flow is a quantity measured over a period of time.

False. Dynamic models are those models that trace the changes that occur in the values of the different variables over time.

True. General equilibrium approach, as compared to a partial equilibrium approach, is a state where all the markets and the decision-making units in the economy are in a simultaneous equilibrium.

False. While Marshall’s name is associated with partial equilibrium analysis, general equilibrium analysis is associated with the French economist Leon Walras.