Economics

Unit 1 – Basic Concept of Macro Economics

Introduction.
Whereas microeconomics deals with the analysis of small individual units of an
economy such as individual consumers, individual firms, individual industries
and markets and explains how prices of products and factors are determined.
On the other hand, macroeconomics is concerned with the analysis of the
behaviour of the economic system in totality. Thus, macroeconomics studies
how the large aggregates such as total employment, national product or
national income of an economy and the general price level are determined.
Macroeconomics is therefore a study of aggregates. Besides, macroeconomics
explains how the productive capacity and national income of the country
increase over a period of time in the long run.
It is evident from above that the subject matter of macroeconomics is to
explain what determines the level of total economic activity I.e., the size of the
national income and employment and fluctuations I.e.., ups and downs in it in
the short run. It also explains what causes the general price level to rise and
determines the rate of inflation in the economy. Besides, modern macro
economics analyses factors which determine national income and rate of
growth of an economy in the long run.
In a free marketwhu does economy go up in one period and falls in another
period? Why do some countries have high rates of inflation, while others
maintain price stability? What causes alternating periods of depression and
boom ?Why should government intervene in the economy and what policy it
should adopt to check inflation, control business cycles, raise level of national
income, reduce unemployment and restore equilibrium in the balance of
payments? are Some of the important questions which macroeconomics
attempts to answer.
Definitions
Kenneth E Boulding
"Macroeconomics is the study of the nature, relationships and behaviour of
aggregates of economic quantities. Macroeconomics deals not with individual
quantities but with aggregates of these quantities not with individual incomes,
but with the national income, not with individual prices, but with the price
levels, not with individual output, but with the national output".
J. M. Culbertson
Macroeconomic theory is the theory of income, employment, prices and
money.
P.A. Samuelson Macroeconomics is the study of the behaviour of the economy
as a whole It examines the overall level of a nation's output, employment,
prices, and foreign trade.

The Origin and Roots of Macroeconomics

The Great Depression. Beginning in late l929, capitalist economies of the world
experienced a severe depression which created a lot of involuntary
unemployment : and also a sharp fall in their GDP .This depression was caused
by drastic decline in private investment. For example, in the United States in
1929, 1.5 million workers were unemployed. The similar situation prevailed in
Britain and other capitalist countries, This depression created a great deal of
controversy among economists about the causes of this depression and the
policies to overcome it and restore full employment.
It was at this time that a noted British economist J.M. Keynes (1883-1946)
challenged the view of classical economists who applied microeconomic
models to explain depression and involuntary unemployment. By emphasising
that the depression and large-scale involuntary unemployment was due to lack
of aggregate effective demand resulting from a fall in private investment he laid
the foundation of modern macroeconomics. In his theory he showed that
economy was not-self-correcting and therefore there was a need for the
government to intervene and take appropriate fiscal measures-to restore full
employment in the economy.
According to Say's Law, supply creates its own demand and therefore, the
problem of lack of demand does not arise .Factors which produce goods and
services for supply in the market get rewards (wages, interest, and rent) Thus,
income earned become expenditure made on goods and services. Therefore,
the problem of deficiency of demand does not arise.
But this theory did not work at the time of unemployment that prevailed
during depression of 1930s in the capitalist economies.
However, the classical model was not found to be true as the depression wad
not self correcting. During the Great Depression of 1930s unemployment
remained at a high level for nearly 10 years.
Though there were pre-Keynesian theories of business cycles and the general
price level that were "macro" in nature, but it was JM. Keynes, an eminent
British economist, who laid stress on macroeconomic analysis and put forward
a general theory of income and employment in his revolutionary book, "A
General Theory of Employment, Interest and Money" published in 1936.
Keynes theory made a genuine break from the classical and neo-classical
economics and produced such a fundamental and drastic change in economic
thinking that his macroeconomic analysis has earned the names "Keynesian
Revolution' and New Economics'.
Keynes in his analysis made a frontal attack on the classical 'Say's Law of
Markets' which was the basis of full-employment assumption. His
macroeconomic model reveals how consumption function, investment
function, interact to determine the level of national income and employment.

After Keynes, there has been significant developments in macroeconomics.

Apart from what determines the level of employment of labour and use of
productive capacity, modern macroeconomics is concerned with many more
issues such as the problems of inflation, economic growth, business cycles, and
the balance of payments and the exchange rate. The analysis of these six major
issues describes the scope of macroeconomics.

Nature of Macroeconomics
Macroeconomics is the study of aggregates or averages covering the entire
economy, such as total employment, national income, national output, total
investment, total consumption, total savings, aggregate supply, aggregate
demand, and general price level, wage level, and cost structure.
 In other words, it is aggregative economics which examines the interrelations
among the various aggregates, their determination and causes of fluctuations
in them. Thus in the words of Professor Ackley, "Macroeconomics deals with
economic affairs in the large, it concerns the overall dimensions of economic
life. It looks at the total size and shape and functioning of the "elephant" of
economic experience, rather than working of articulation or dimensions of the
individual parts.
Macroeconomics is also known as the theory of income and employment, or
simply income analysis. It is related with the problems of unemployment,
economic fluctuations, inflation or deflation, international trade and economic
growth. It is the study of the reasons of unemployment, and the various factors
of employment.
In the field of business cycles, it relates itself with the effect of investment on
total output, total income, and aggregate employment. In the monetary
domain, it studies the effect of the total quantity of money on the general price
level.
In international trade, the problems of balance of payments and foreign aid fall
within the domain of macroeconomic analysis. Above all, macroeconomic
theory deliberates the problems of determination of the total income of a
country and causes of its fluctuations. Finally, it studies the factors that delay
growth and those which bring the economy on the path of economic
development.

Scope of Macroeconomics.
1.Employment and Unemployment
Macroeconomics explains what determines the level of employment and
national income in an economy and therefore what causes involuntary
unemployment. Classical economist denied that there could be involuntary
unemployment of labour and other resources for a long time They thought that
unemployment would be automatically removed with changes in wage n price
and full employment will established. But this did not appear to be so at the
time of depression in the thirties.
Keynes explained that level of employment and national income is determined
by aggregate demand and aggregate supply. With aggregate supply remaining
unchanged in the short run is the deficiency of aggregate demand that cause
underemployment . According to him, it is the changes in private investment
that cause fluctuations in aggregate demand and is therefore, responsible for
the problems of cyclical unemployment

2. Determination of National Income (or GNP).

National income is the value of all final goods and services produced in a
country in a year. Level of national income or what is called Gross National
Product (GNP) shows the performance of the economy in a year and
determines the overall living standards of the people of a country. The higher
the per capita national income, the greater the amounts of goods and services
available for consumption per individual on an average.
It is important to note that in a developing country such as India it is not a
mere level of aggregate demand that determines national income. In it the
supply-side factors such as availability of physical capital, human capital (skills
and education of people), material resources, the technology used for
production in agricultures and industries play a more important role in the
determination of national income.
3. General Price Level and Inflation.
Another macroeconomic issue is to explain the problem of inflation. Inflation
haş been a major problem faced by both the developed and developing
countries in the last fifty years. Classical economists thought that it was the
quantity of money in the economy that determined the general price level in
the economy and, according to them, rate of inflation depended on the money
supply in the economy. Keynes criticised the` Quantity Theory of Money' and
showed that expansion in money supply did not always lead to inflation or rise
in price level. Keynes put forward what is now called demand-pull theory of
inflation. After Keynes, theory of inflation has been further developed and
many theories of inflation depending upon various causes have been put
forward. Cost-push and structuralist theories of inflation have been put
forward. To analyse the problem of inflation is an important issue of
macroeconomics.
4. Business Cycles
 Business cycles refer to fluctuations in output and employment with
alternating periods of boom and recession. In boom periods both output and
employment are at high levels, whereas in recession periods both output and
employment fall and as a consequence large unemployment come to exist in
the economy. When these recessions are extremely severe, they are called
depressions.
What are the causes of these business cycles or ups and dawns in market is an
important macroeconomic issue .The objective of macroeconomic policy is to
achieve economic stability with equilibrium at full employment level of output
and income.
5. Economic Growth
Another important issue in macroeconomics is to explain what determines
economic growth in a country. Economic growth means sustained increase in
national income (GNP) or per capita income over a sufficiently long period of
time. Given the availability of natural resources, economic growth of a country
depends on the growth of physical capital, human capital and progress in
technology. The growth of all these factors requires saving and investment.
Theory of economic growth or what is simply called growth economics which
has been recently developed a good deal is an important branch of
macroeconomics, The problem of growth is a long run problem and Keynes did
not deal with it. In fact, It was Harrod and Domar who extended the Keynesian
analysis to the long-run problem of growth with stability.
6. Balance Of payment and Exchange Rate
Balance of payments is the record of economic transactions of the residents of
a country with the rest of the world during a period.The aim to prepare such a
record is to present an account of all receipts of goods exported, services
rendered and capital received by the residents of a country and the payments
made for goods imported, services received and capital transferred to other
countries by residents of a country. There may be deficit or surplus in balance
of payments. Both create problems for an economy. An impor tant effect is that
the transactions in balance of payment are influenced by the exchange rate.
The exchange rate is the rate at which a country's currency is exchanged for
foreign currencies. The instability in exchange rate has been a major problem in
recent years which has given rise to Serious balance of payments problems.
This creates the situation of economic crisis and is a major art of study of
macroeconomics.

Importance Of Macroeconomics
1.To Understand the Working of Macroeconomy : Macroeconomic Paradoxes,
The study of macroeconomics is important in its own sake, as it tells us how the
economy as a whole works We cannot obtain and derive the laws governing
macroeconomic variables such as national income, total employment, general
price level by studying the microeconomic decisions of individual consumers,
firms and industries.(This is because what is true and valid in case of an
individual firm or industry may not be valid for the economy as a whole
For eg.1. In the case of wages all-round cut in wage rates to promote
employment and thereby to solve the problem of unemployment won’t be
correct. At a lower wage rate, an individual firm or industry will employ more
labour. But this does not apply to the whole economy.. Fall in wages means
decline in their incomes which would lead to a fall in aggregate demand for
goods and services. This fall in aggregate demand will cause national output
and employment to decline. Thus, from the viewpoint of the economy as a
whole cut in wages will increase unemployment of labour rather than reducing
it.
Eg2. When an individual saves more he is able to invest more and the higher
investment yields more income for him in the future. But this result does not
necessarily apply to the case when a society saves more. Suppose at the time
recession a society as a whole decides to save more.This happens because
more saving than before leads to the decrease in aggregate demand for goods
and services..The fall in aggregate demand will cause the level of national
income to decline and at the lowerlevel of national income, less saving will be
done. This is called paradox of thrift.
 The above examples of macroeconomic paradoxes clearly reveal that a
separate macro Economic analysis is important to understand the working of
the economy as a whole.

2. For Accelerating Economic Growth.

Macroeconomics explains the factors which determines economic growth and
brings out what causes of slowdown in productivity .Higher rate of economic
growth helps in solving the problems of poverty and unemployment in the
developing countries like India. Macroeconomic models of Harrod-Domar and
Solow reveal that increase in the rate of saving and investment and
improvement in technology are the important factors determining economic
growth. Thus, macroeconomic provides us knowledge as to how to achieve
self-sustained economic growth.
3.Understanding Business Cycles.
Business cycles have been the biggest ailment of market economics.
Fluctuations in aggregate demand due to volatile nature of investment
demand, multiplier and accelerator provides an adequate explanation of
business cycles. It is because of this understanding about business cycles that
has helped to adopt proper fiscal and monetary policies to check business
cycles and also due to these policies that severity of business cycles in recent
years has greatly reduced. This shows that important contribution made by
macroeconomics in controlling business cycles.
4. Formulating Government's Macroeconomic Policies.
With the knowledge of the causes of recession and inflation brought out by
macroeconomics governments formulate proper fiscal and monetary policies
to tackle them. During recession, expansionary fiscal and monetary policies are
adopted to lift the economy out of recession. On the other hand, in inflation h
tight monetary policy and contractionary fiscal policies adopted.
5. Individual Decision-Making
The understanding about the working of the economy as a whole helps the
individuals to take better decisions. For example, If on the basis of certain
Government's economic policy they predict that inflation rate will increase,
they may decide to act in the present in a way to to save themselves from the
undesirable consequences of inflation. Similarly people's decisions about
whether or not to buy a house, or a new car would be based in goverments
policies.

6.Importance in business decisions.

The understanding of M.E helps businesses and managers who are faced with
various decision-making problems. Business firms do not work in vacuum, The
level of overall economic activitydi.e. national income and employment,
aggregate demand conditions, government's policies like fiscal and monetary
the rate of inflation affect business firms.These aggregates of the economy
make up overall business environment which affects decisions of managers.

Limitations Of Macroeconomics.

(1) Fallacy of Composition

In Macroeconomic analysis the *fallacy of composition" is involved, i.e.,
aggregate economic behaviour is the sum total of individual activities. But what
is true for individuals is not necessarily true for the economy as a whole.
For example, savings are a private virtue but a public vice. If total savings in the
economy increase, they may initiate a depression unless they are invested.
Again, if an individual depositor withdraws his money from the bank there is no
problem. But if all depositors do this simultaneously, then the banking system
will be adversely affected.
(2) Difficulties in measuring the Aggregates
The main flaw in macro analysis is that it regards the aggregates as
homogeneous without thoughtful about their internal composition and
structure. The average wage in a country is the sum total of wages in all
occupations, i.e., wages of clerks, typists, teachers, nurses, etc. But the volume
of aggregate employment depends on the structure of wages rather than on
the average wage. If, for instance, wages of nurses' increase but of typists fall,
the average may remain unchanged. But if the employment of nurses falls a
little and of typists rises much, aggregate employment would increase.

3. Aggregate Variables may not be Important Necessarily The aggregate

variables which form the economic system may not be of much significance.
For instance, the national income of a country is the total of all individual
incomes. A rise in national income does not mean that individual incomes have
risen.
The increase in national income might be the result of the increase in the
incomes of a few rich people in the country. Thus a rise in the national income
of this type has little significance from the point of view of the community.
Prof. Boulding calls these three difficulties as "macroeconomic paradoxes"
which are true when applied to a single individual but which are untrue when
applied to the economic system as a whole.
4.Statistical and Conceptual Difficulties
Some economists consider M.E. only as an “intellectual Attraction” without
much practical use.
Most of M.E factors such as Gross National Product, Fixed capital investment,
Balance e of Payments ,Employment are subject to errors and has ambiguities.
And such erroneous aggregates present a wrong and misleading picture of
economy.

Macro Economic Variables .

1.Economic Growth. Achieving and maintaining a high rate of economic growth
has been a matter of great concern for both the developed and the
underdeveloped countries, The main macroeconomic issues that countries l
are currently faced with are:
-How to maintain the current high growth rate:
-How to prevent the overheating of the economy-a problem often associated
with fast growing economies; and
- How to keep inflation under control within its tolerable and desirable limits.
Thus ,achieving and maintaining a sustainable growth rate has for long been
one of the main macroeconomic issues. The growth related issues are
becoming more ore complex with the rapid globalisation of the world economy
and the consequent growing complexities.

2. The Issue of Business Cycles

Business cycle refers to high magnitude of fluctuation in the economy-high
growth in GDP/GNP in one period followed by a sharp decline in the next
period. Thus, business cycle is also referred the period of economic boom and
depression. During boom and prosperity, there is high rat of growth in GDP and
high rate of employment, and during depression, there is fast decline in GDP
and high rate of unemployment. The recurrence of this kind of growth and
depression in the economy is called business cycle.
3. Inflation
Inflation is another and equally important macroeconomic problem faced by
the countries at different points of time, especially by the fast growing
economies. Inflation is defined as persistent and considerable increase in the
price level over a long period of time. A moderate rate of inflation is considered
to be desirable for the economy--2-3 percent for developed countries and 4-5
percent for developing economies. Inflátion in excess of these rates is
economically and also socially undesirable and is rather dangerous for the
economy .
It also creates economic,social and political problems in the country. Thus its
considered as a serious macroeconomic problems which requires suitable
policy measures and effective implantation of policy.

4. Unemployment and Poverty

Unemployment refers to that part of the labour force, or workforce, which is
willing to work at the prevailing wage rate and is looking for a job but is not
getting employment. The level of unemployment in a country is measured in
terms of percentage of out-of-job labour force to total labour force. Labour
force is that part of manpower which is willing to work at the on-going
wages.Unemployment over a period of time -a period of six months or a year
or for a longer period results in poverty of unemployed people.A high rate of
unemployment has remained a dominant and a persistent economic issue in
most of the countries.
5. Budgetary Deficits
The govt budget refers to the annual revenue and expenditure of the
government of a country. In the post world war 2 period , Govt. budget
emerged as a powerful tool of macroeconomic management control and
regulation of the economy .
And when the govt spending increases more than its revenue , hovt faces fiscal
deficit. Deficits could be financed by government borrowings resulting in
increased national debt. It may prove inflationary, if the economy fails to
generate more output.
.Although budgetary deficits can be managed simply by cutting down public
expenditure and increasing the tax rate, this measure too has serious adverse
implications for the economy as a whole. So this method cannot be adopted
straightaway. Thus, the most important and common macroeconomic problem
related to government budget is the growing budgetary deficits.