BET 104: MACROECONOMIC THEORY I

LECTURE I AND 2

INTRODUCTION

Economics is a social science which studies the allocation of scarce resource that have
potential alternative uses among competing an virtually limitless wants of consumers in the
society. The term “economy” from which we obtain the word “economics” was originally
derived from the Greek word “oikonomia” which was also on the other hand derived from the
word “oikonomos”. “Oikonomos” seperates into “oikos” meaning house and “nomos”
meaning “managing”. In a general sense, Economics is the study of production, distribution
and consumption.

The two main fields of study in economics are microeconomics and macroeconomics.
Microeconomics deals with markets and decision making of individual economic units,
including consumers and firms. On the other hand, macroeconomics deals with aggregate
economic quantities such as national output and national income. Macroeconomics has its
roots in microeconomics.

Scientific theories seek to explain phenomena associated with the macroeconomy. The
primary phenomena investigated are unemployment, inflation, and the level of aggregate
production. Macroeconomic theories also inevitably provide policy recommendations
intended to improve the performance of the economy and to correct macroeconomic
problems.

The major goals/aims of Macroeconomic Policy

Macroeconomics policy aims to achieve:

• Full employment
Unemployment is where some resources are not optimally utilized and are lying idle.
Full employment is favoured because the greater the level of employment, the
greater the amount of goods and services available in the economy. It is also argued
that the burden of unemployment and loss of goods and services fall
disproportionately on people who are without jobs.
• Price stability
Inflation should be avoided at all costs so that prices remain stable and predictable
over time. This is important because inflation affects other people more adversely
than others. For example, people whose incomes rise more rapidly than prices and
those who are able to borrow at relatively low interest rates prior to inflation benefit
from inflation.
• Economic growth
 Economic growth takes place when real output increases more rapidly than the
increase in population, thus with economic growth the society has more goods and
services at its disposal and a correspondingly higher standard of living.
• External balance
If a country has a favourable balance of payment (BOP), its foreign exchange
reserves will increase, hence can import the much needed capital for investment.
Unfavorable BOP would lead to an outflow of foreign exchange to finance the trade
deficit

BASIC CONCEPTS IN MACROECONOMIC ANALYSIS

a. Aggregate Demand and Supply

The key concepts in macroeconomics are aggregate demand and aggregate supply. In an
economy, the level of output and the price level are determined by the interaction of
aggregate demand and aggregate supply.

In economics, aggregate demand is the total demand for final goods and services at a given
time and price level. It gives the amounts of goods and services that will be demanded at all
possible price levels, which, unless there are shortages, is equivalent to GDP. Aggregate
demand equals the sum of consumption (C), investment (I), government spending (G), and
net export (X -M). This is often written as an equation, which is given by:

AD = C + I + G + (X – M).

Aggregate demand is the relationship between spending on commodities and the level of
prices. When unemployment is high, increased spending — or an increase in aggregate
demand — will raise output and employment with little effect on prices. For example, during
the Great Depression of the 1930s, it would certainly be appropriate to use expansionary
aggregate demand policies.

The aggregate demand curve is downward sloping but in variation with microeconomics, this
is as a result of three distinct effects: the wealth effect, the interest rate effect and the
exchange-rate effect.

Basically individuals will consume or purchase more when they feel wealthier or have access
to inexpensive funding.

The wealth effect is specifically related to the value of assets; market participants will adjust
consumption in-line with their perception of the appreciation or depreciation of held assets (a
home; equity investments, etc.). The interest rate effect has to do with access to inexpensive
funding, which provides an incentive to increase current period expenditures; while the
exchange-rate effect has to do with expenditure decisions related to imports or foreign related
expenditures, as the exchange rate is perceived to be favorable to the domestic currency,
expenditures on foreign items or imports will increase.
But if the economy is close to full employment, increased aggregate demand will be
inflationary. The aggregate supply side of the economy has to be introduced. The aggregate
supply curve specifies the relationship between the amount of output firms produce and the
price level.

The supply side not only tells us how successful demand expansions will be in raising output
and employment, but it also has a role of its own. In economics, aggregate supply is defined
as the total supply of goods and services that firms in a national economy produce during a
specific period of time. It is the total amount of goods and services that firms are willing to
sell at a specific price level in the economy. Supply shocks can reduce output and raise
prices, as was the case in the 1970s when the price of oil increased sharply. Conversely,
policies that increase productivity — and hence aggregate supply — can help reduce
inflationary pressure.

b. National Income and Output

One of the most important concepts of macroeconomics is income and output. The national
output is the total amount of all goods and services produced in a country during a specific
period. And when production units sell everything they produce, they generate an equal
amount of income. Hence, you can measure output by calculating the total income from the
sale of all goods and services.

In relation to macroeconomics, economists usually measure national income or output by

gross domestic product or GDP. By measuring GDP, economists can understand the market
swings and changes. They can identify what measures to take to improve the GDP of the
country. With technological advances, capital increase, and acquisition of state-of-art
equipment, production units and organizations can increase national output and income.
However, income and output can be affected by recessions and other market factors.

The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-wide
fluctuations in production, trade, and general economic activity. From a conceptual
perspective, the business cycle is the upward and downward movements of levels of GDP
(gross domestic product) and refers to the period of expansions and contractions in the level
of economic activities (business fluctuations) around a long-term growth trend.

Business cycles are identified as having four distinct phases: expansion, peak, contraction,
and trough.

An expansion is characterized by increasing employment, economic growth, and upward

pressure on prices. A peak is realized when the economy is producing at its maximum
allowable output, employment is at or above full employment, and inflationary pressures on
prices are evident. Following a peak an economy, typically enters into a correction which is
characterized by a contraction, growth slows, employment declines (unemployment
increases), and pricing pressures subside. The slowing ceases at the trough and at this point
the economy has hit a bottom from which the next phase of expansion and contraction will
emerge.

The repeated periods during which real GDP falls, and such periods are called recessions if
they are mild and depressions if they are more severe.
 c. Unemployment

Another important component of macroeconomics is unemployment. Economists measure the

unemployment rate in an economy by calculating the percentage of individuals without jobs.
Unemployment categories include classic unemployment, frictional unemployment, and
structural unemployment.

Classical unemployment is when wages are too high for employers to consider hiring more
workers. Frictional unemployment occurs when the time taken to search for an appropriate
employee is too long. Structural unemployment occurs when there is a mismatch between a
worker’s skills and the actual skill required for a job. Another important category of
unemployment is cyclical unemployment that occurs when an economy’s growth is stagnant.

d. Inflation and Deflation

The study of inflation and deflation is another important aspect of macroeconomics. The term
inflation refers to an increase in the prices of goods and services across the country. And the
term deflation refers to a decrease in the prices of goods and services. Economists measure
inflation and deflation by studying price indexes. A price index is the weighted average of
price for a class of products and services.

Inflation occurs when an economy grows too quickly. Deflation, on the other hand, occurs
when an economy declines over a period of time. By studying the inflation and deflation
trends, economists can help curb inflation rates by taking appropriate measures. Too much
inflation can lead to negative consequences and continuous deflation can cause low economic
output.

e. Consumption, Savings, and Investment

Aggregate demand met by the market is spending, be it on consumption, investment, or other

categories.

Spending is related to income:

Income – Spending = Net Savings

Rearranging:

Spending = Income – Net Savings = Income + Net Increase in Debt

In words: what you spend is what you earn, plus what you borrow: if you spend KES. 110
and earned KES. 100, then you must have net borrowed KES. 10; conversely if you spend
KES. 90 and earn KES. 100, then you have net savings of KES. 10, or have reduced debt by
KES. 10, for net change in debt of –KES. 10.

For the economy as a whole, aggregate savings is greater than or equal to investment, which
is usually in the form of borrowed funds available as a result of savings. Through investment
spending, savings influences aggregate demand.

f. Prices: Flexible Versus Sticky

Economists normally presume that the price of a good or a service moves quickly to
bring quantity supplied and quantity demanded into balance. In other words, they assume that
markets are normally in equilibrium, so the price of any good or service is found where the
supply and demand curves intersect. This assumption is called market clearing. For
answering most questions, economists use market-clearing models.

Yet the assumption of continuous market clearing is not entirely realistic. For markets to
clear continuously, prices must adjust instantly to changes in supply and demand. In fact,
many wages and prices adjust slowly. Labor contracts often set wages for up to three years.
Many firms leave their product prices the same for long periods of time—for example,
magazine publishers typically change their newsstand prices only every three or four years.
Although market-clearing models assume that all wages and prices are flexible, in the
real world some wages and prices are sticky.

The apparent stickiness of prices does not make market-clearing models useless. After all,
prices are not stuck forever; eventually, they adjust to changes in supply and demand.
Market-clearing models might not describe the economy at every instant, but they do describe
the equilibrium toward which the economy gravitates. Therefore, most macroeconomists
believe that price flexibility is a good assumption for studying long-run issues, such as the
growth in real GDP that we observe from decade to decade.

For studying short-run issues, such as year-to-year fluctuations in real GDP and
unemployment, the assumption of price flexibility is less plausible. Over short periods,
many prices in the economy are fixed at predetermined levels. Therefore, most
macroeconomists believe that price stickiness is a better assump- tion for studying the short-
run behavior of the economy.

g. Stocks and Flows

Stock and flow variables are an important distinction in macroeconomics. A flow variable has
a time dimension. It is always measured over a period of time. A stock variable has no time
dimension. It is measured at a given point in time. The stock variable is just a number, not a
rate flow of so much per period. For example, the concepts like total money supply, total
bank deposits, etc. are stock concepts whereas the concepts like national income, national
output, total consumptions, etc. are flow concepts.

When we measure the national income we consider a period of time, namely one year. Thus
national income is measured as a flow per year. Similarly, total investment, total saving, total
consumption etc. are expressed as amount per year — so they are flow concepts. But the total
supply of money is a stock concept which is measured on a particular point in time. Thus,
flow variable must specify the period of time to which this flow refers.

If we talk about the income of an individual we must mention the time period of this income
flow. If we say that the individual has an income of KES. 10,000, it is meaningless because
we have not mentioned the time period. If the time period is one month, it means something
— that the individual is earning KES. 10,000 per month or KES. 120,000 per year. Thus, the
time period of a flow variable is very important.
However, the stock variable is measured without any reference to time period. In economics
we use both flow variables and stock variables and it takes a little practice to master these
concepts. The main test is whether a time dimension is needed to give the variable meaning.

h. The Concept of Equilibrium:

Equilibrium is a concept borrowed from mechanics where we get the idea of equilibrium
system of forces. In mechanics a system of forces is said to be in equilibrium if two forces
making to move the body in opposite directions are counter-balanced. Thus, an equilibrium
situation is a state of rest.

In economics we use the term to mean that a single price for a product is established in a
market and when no economic forces are being set up to change that price. In other words, in
equilibrium, the price and quantity of a commodity match both consumers’ and producers’
expectations and thus there is no discrepancy between the actual and desired prices and
quantities.

Consequently, market is cleared and there are no involuntary holdings of unsold stocks. The
equilibrium behaviours of consumers and producers — whether in a single market or in the
economy as a whole — is characterised by the fact that there exists no feeling of urgency on
the part of the buyers and sellers to change their behaviour.

In contrast, disequilibrium situation is one in which some buyers and sellers feel compelled to
change their behaviour because forces are at work that change their circumstances. By
changing their behaviour, however, they change the circumstances of other producers and
consumers who may initially have been in equilibrium. A disequilibrium sets in motion a
chain of adjustment and readjustment processes; for example, on the stock market, buyers
and sellers change their behaviour daily in response to changing circumstances.

The economy as a whole would be in equilibrium when the planned demand for output is
equal to planned supply of output. The whole economy would be in equilibrium when
aggregate demand equals aggregate supply.

Levels of economic analysis

i. Comparative statics versus dynamics

Comparative statics analyses and compares two or more equilibrium positions,

without considering the transitional period and the process involved in the
adjustment.

Dynamics on the other hand, considers the time path and the process of
adjustment itself.

ii. Partial Equilibrium versus general equilibrium

Partial equilibrium refers to the study of behavior of individual decision-making

units and the functioning of individual markets viewed in isolation.
 General equilibrium analysis analyses the behavior of all individual decision-
making units and all individual markets simultaneously.

i. Scarcity and Choice

If resources available in an economy are insufficient to satisfy all their needs, then such
resources are deemed to be scarce. Therefore, the problem of scarcity in resources brings
about choices. Choices have to be made because resources are limited and one can only have
more of X by having less of Y.

Economic resources are scarce or limited in supply and they command a price e.g. land,
labour and capital.

Non-economic resources are unlimited in supply, are free and do not require the use of scarce
production factors. For example air.

Therefore, economics is concerned with economics resources and the three fundamental
choices to be made by any societ are;

i. Which goods and services to produce and in which quantities?- Deals with the
composition of total output.
ii. How should the goods and services be produced?- This deals with whether the
goods are labour-intensive or capital-intensive
iii. How shouldthe goods and services be distributed?- Deals with how goods and
services produced are divided in the society

j. Opportunity Cost

The opportunity cost of an action is the value of the best forgone alternative action.
Opportunity cost arises because resources are scarce and have alternative uses. The concept
of opportunity cost, for example, applies to the government in its decisions concerning
alternative spending programmes. For example, if a decision is taken to build a school, then
the resources used cannot be channeled to the building of a hospital. The opportunity cost of
building the school is therefore the building of the hospital which is forgone.

k. The production possibility frontier

This is a graph that shows combinations of goods and services which can be produced with a
given level of resources. This concept can be applied at the level of an individual firm or at
the level of a country. It shows the possibilities open for increasing the output of one good by
reducing the output of another and therefore provides an excellent application of the concept
of opportunity cost.
l. Economic Models

Economists use models to understand the world. Models, which comprise of an equation or a
set of equations, are theories that summarise the relationship among economic variables.
Models help in explaining economic variables, such as GDP, inflation, and unemployment.
Economic models illustrate, often in mathematical terms, the relationships among the
variables. Models are useful because they help us to dispense with irrelevant details and to
focus on underlying connections.

Therefore, a model is a description of reality with some simplification. To simplify analysis

each model makes some assumptions which must be explicitly stated when a model is
formulated.

Models have two kinds of variables: endogenous variables and exogenous variables.
Endogenous variables are those variables that a model tries to explain.

Exogenous variables are those variables that a model takes as given. The purpose of a model
is to show how the exogenous variables affect the endogenous variables. In other words,
exogenous variables come from outside the model and serve as the model’s input, whereas
endogenous variables are determined within the model and are the model’s output.

For example, let us see how we can develop a model for bread. We assume that the quantity
of bread demanded, Qd, depends on the price of bread, Pb and on aggregate income Y. This
relationship is expressed in the equation Qd = D(Pb, Y) where D denotes the demand function.
Similarly, we assume that the quantity of bread supplied, Qs, depends on the price of bread,
Pb, and on the price of flour, Pf, since flour is used to make bread. The relationship is
expressed as Qs = S (Pb, Pf), whereas S denotes the supply function. Finally, we assume that
the price of bread adjusts to equilibrate demand and supply: Qd = Qs. These three equations
compose a model of the market for bread.

Economic relationships involved in a model may be of different types.

Firstly, the relations could be behavioural. For example, consider the saving function S =
S(Y), which states that saving (S) is a function of income (Y).

Secondly, relationship between the variables could be technical. The technical relationships
follow from technological considerations. For example, consider the production function Y =
F (K, L) which states that total output (Y) produced is a function of total capital employed
(K) and total labour employed (L). This relationship is determined by the technological
consideration underlying the production process. Hence it is a technical relationship.

Thirdly, the relationship may be definitional. Such relationships follow from the very
definitions of the variables. For example, if Ym represent money income, Yr represents real
income and P represents price level, then Ym = Yr X P represents a definitional equation.

m. The methodology of Economics

Economics uses scientific method to develop its theories. A useful insight into the
methodology applied in economics can be gained by distinguishing between positive and
normative economics.

Positive economics is concerned with WHAT IS, or how the economic problems facing the
society are actually solved. Positive economics therefore deals only with facts e.g Kenya’s
largest export market is Uganda.

Normative economics, on the other hand, deals with value judgements. I is concerned with
WHAT OUGHT TO BE. Therefore, it deals with how economic problems facing the society
should be solved. For example; since Kenya’s trade performance in the EAC has fallen, the
country should join SADC so as to expand its export market.

Economics majorly deals with theories. A theory is a general or unifying principle that
describes and explains the relationship between things observed I the world around us. The
purpose of theory is to predict and explain. The search for a theory begins whenever a
definite regular pattern is observed in the relationship between two or more variables.
Therefore, a theory is a hypothesis that has been successfully tested and the following steps
are adopted in the scientific method;

i. The concepts are defined in such a way that they can be measured inorder to be
able to test the theory against facts
ii. Hypothesis formulation- a hypothesis refers to a tentative untested statement
which attempts to explain how one thing is related to another. The formulation of
hypothesis is arrived at through aproces of logical reasoning using observed facts
and certain assumptions.
iii. A hypothesis is then used to make predictions- if the hypothesis is correct, then if
certain things are done, certain others will happen. For example, a hypothesis
might predict that a rise in the price of a commodity will lead to a fall in the
quantity demanded of that commodity.
iv. The hypothesis is tested by considering whether its predictions are supported by
facts- In order to test the hypothesis and arrive at a theory, one must go to the real
world and check whether the hypothesis is indeed true for various situations.
Therefore, observed economic data is subjected to statistical analysis whose
 techniques help the economist determine the probability that particular events
have certain causes.

n. Macroeconomic Policies

The two main macroeconomic policies that a government may apply to bring about stability
are the monetary policy and the fiscal policy.

1. Monetary Policy

The monetary policy is an important process, which is under the control of the monetary
authority of a country. This monetary authority is usually the central bank or the currency
board. The monetary policy is usually implemented by the central bank to stabilize prices and
to increase the strength of a country’s currency.

The monetary policy also aims to reduce unemployment rates and stabilize GDP. It also
controls the supply of money in an economy. For example, the central bank of a country can
pump money into an economy by issuing money to buy bonds and other assets. On the other
hand, the central bank of a country can also sell bonds and take money out of circulation.

2. Fiscal Policy

The fiscal policy is a process that makes use of a government’s revenue generation and
expenditure as tools to control economic windfalls. The government uses the fiscal policy to
stabilize the economy during a business cycle. For instance, if production in an economy does
not match the required output, the government can spend on idle resources and help in
increasing output.

Usually, economists prefer the monetary policy over the fiscal policy. This is because the
monetary policy is under the control of the central bank of a country, which is an independent
organization. The fiscal policy is under the control of the government, which can be affected
by political intentions.

HISTORICAL OVERVIEW OF MACROECONOMIC THEORIES

A number of macroeconomic theories have been developed over the decades. They are often
aimed at addressing pressing economic problems of the day. In that the pressing economic
problems tend to be unemployment, inflation, or stagnant growth, most macroeconomic
theories make a concerted effort to shed light on these issues.

 Classical Economics: The granddaddy of macroeconomic theories stems from the

groundbreaking work of Adam Smith, the father of modern economics. This theory is
based on the notion that flexible prices ensure market equilibrium such that full
employment production is maintained. The primary policy implication is that
government intervention is not needed to maintain economic stability.

Price AS
Level
 P1

P0

AD2
AD1

Full Output
employment
Output

From the diagram, note that since the economy is in full employment level, any changes in
price do not alter the equilibrium output.

 Keynesian Economics: Developed by its namesake, John Maynard Keynes, this

theory was in response to the massive unemployment problems of the Great
Depression of the 1930s. John Maynard Keynes published a book in 1936 called The
General Theory of Employment, Interest, and Money, laying the groundwork for his
legacy of the Keynesian Theory of Economics. Keynesian Economics rests on the
presumption that aggregate demand for production is the primary source of business-
cycle instability. The primary policy implication is that economic instability runs
rampant without government intervention.

Price
Level
Price
Level
 AS
P0 AS

AD2

AD1 AD2

Y2

Y1 Y2 Output

From the diagram, the Keynesian AS is horizontal indicating that firms will supply whatever
amount of goods is demanded at the existing price level. This is because there is
unemployment and firms can obtain as much labour as they want at the current wage.

Main Tenets

With this overview in mind, Keynesian Theory generally observes the following concepts:

 Unemployment: Under the classical model, unemployment is often attributed to high

and rigid real wages. Keynes argues there is more complexity than that, specifically
that societies are highly resistant to wage cuts and furthermore that reducing wages
would pose a great threat to an economy. Specifically, cutting wages reduces
spending and may result in a downwards spiral.
 Excessive Saving: in short Keynes notes excessive saving as a threat and prospective
cause of economic decline. This is because excessive saving leads to reduced
investment and reduced spending, which drives down demand and the potential for
consumption.
 Fiscal Policy: The key concept in fiscal policy for Keynes is ‘counter-cyclical’ fiscal
policy, which is the expectation that governments can reduce the negative effects of
the natural business cycle. This is, generally, achieved through deficit spending in
recessions and suppression of inflation during boom times. Simply put, the
government should try to curb the extremes of economic fluctuation through informed
fiscal policy.
 The Multiplier Effect: This idea has in many ways already been implied in the atom,
but inversely. Consider the unemployment and excessive savings problems, and how
they stand to lead to spiraling decline. The other side of that coin is that positive
economic situations can spiral upwards. Take for example a government investment
in transportation, putting money in the pockets of various individuals who build trains
and tracks. These individuals will spend that extra capital, putting money in the hands
of other business (and this will continue). This is called the multiplier effect.
 IS-LM: While the IS-LM Model is a complicated byproduct of Keynesian economics,
it can be summarized as the relationship between interest rates (y-axis) and the real
economic output (x-axis). This is done through analyzing the invest-saving
relationship (IS) in contrast to the liquidity preference and money supply relationship
(LM), generating an equilibrium where certain interest rates and outputs will be
generated.
Moneterist Theory

It is attributed to Milton Friedman. The basic premise is that the supply of money and the role
of central banking play a critical role in macroeconomics. When the money supply is
expanded, individuals will be induced to higher spending. In turn, when the money supply
retracted, individuals would limit their budgetary spending accordingly. This would
theoretically provide some control over aggregate demand (which is one of the primary areas
of disagreement between Keynesian and classical economists).

Neoclassical Economics

In approaching Neoclassical economics, it is most important to keep in mind the following

three principles:

1. People have rational preferences in the context of options or outcomes that can be
identified and associated with a given value (usually monetary). In short, people make
smart choices regarding how they spend their money.
2. Individuals maximize utility and firms maximize profit. People will try to get the most
from their money while corporations will try to invest their time and assets to capture
the highest margin.
3. People act independently based upon comprehensive and relevant information. People
are influenced by rational forces (mostly information and logic), and will make the
best personal purchasing decisions based upon this.

A brief timeline of classical to neoclassical perspectives would begin with thought processes
put forward by Adam Smith and David Ricardo (alongside many others). The basic idea is
that aggregate demand will adjust to supply, and that value theory and distribution will reflect
this rational, cost of production model. The next phase was the observation that consumer
goods demonstrated a relative value based on utility, which could deviate from consumer to
consumer. The final phase, and most central to the advent of the neoclassical perspective, is
the introduction of marginalism. Marginalism notes that economic participants make
decisions based on marginal utility or margins. For example, a company hiring a new
employee will not think of the fixed value of that employee, but instead the marginal value of
adding that employee (usually in regards to profitability).

Neo-Keynesian

Neo-Keynesian economics is actually the formalization and coordination of Keynes’s

writings by a number of other economists (most notably John Hicks, Franco Modigliani, and
Paul Samuelson). Much of the conceptual value is captured in the previous atoms on
Keynesian views, but the substantial value of a few neo-Keynesian ideas is worth reiterating:

 IS/LM Model: This model was put forward by John Hicks in order to capture the
inherent relationship between investment and savings (IS) relative to liquidity and the
overall money supply (LM) (see ). The implications of this graph pertain to the static
representation of monetary policy and the effects on an economic system.
 Phillips Curve: Another important model following Keynes’s publications is the
Phillips Curve, put forward by William Phillips in 1958. The idea here was also
largely Keynesian, revolving around the relationship between inflation and
unemployment (see ).This implies a trade off between inflation rates and the creation
 of employment, which governments could consider in policy making. Stagflation
(economic stagnation and inflation simultaneously) created issues with this however,
necessitating New Keynesian ideas (as discussed briefly above).

New Classical Economics

This theory emerged in the 1970s as a rebirth of Classical economics. It contends that
people have rational expectations about the consequences of government policies, which
then negates the impact of the policies. As such, like Classical economics, the primary
implication is the economy maintains full employment without the need for government
intervention.