Set by : MR. Tilahun W.

“In the long run we all are dead” – John Maynard Keynes

CHAPTER ONE

INTRODUCTION TO MACROECONOMICS

1. What Macroeconomics is about?

 Economics is the study of the economy and the behaviour of people in the economy.

Traditionally, economics is divided into microeconomics, which studies the behaviour of

individuals and organizations (consumers, firms and the like) at a disaggregated level,

 macroeconomics, which studies the overall or aggregate behaviour of the economy. Since

our interest here is with macroeconomics, we seek to explain phenomena such as

inflation, unemployment, and economic growth and we are not concerned with, say, the

demand for or supply of a specific commodity.

Macroeconomics is concerned with the behaviour of the economy as a whole- with respect to :-

 booms and recessions

 the economy’s total output of goods and services

 the growth of output the rate of inflation

 unemployment

 balance of payments

 exchange rates.

Macroeconomics focuses on :-

 the economic behaviour and policies that affect consumption

 investment, trade balance

 the determinants of changes in wages and prices

 monetary and fiscal policies

 the money stock,

 Set by : MR. Tilahun W.

“In the long run we all are dead” – John Maynard Keynes

 government budget,

 interest rate, and national debt.2

In macroeconomics, we do two things.

✓ First, we seek to understand the economic functioning of the world we live in; and,

✓ Second, we ask if we can do anything to improve the performance of the economy. 2

2Macroeconomic Goals, Instruments and Methods of Analysis

Macroeconomic Goals

Macroeconomic policy makers design various policies to achieve desirable outcomes in the

macroeconomic goals that are generally desired by societies. The primary goals for the macro

economy (among others) are:

 Economic growth

 Low unemployment or Full employment

 Price stability or low inflation

 Equitable Distribution of Income2

Framework / Method of Macroeconomic Analysis

➢ Aggregate Demand / Aggregate Supply

➢ Keynesian Model

➢ Classical Model 2

Policy Instruments2

➢ Fiscal Policy- which mainly involves changes in government spending/purchases and taxes

➢ Monetary Policy- which involves managing the money supply and interest rates.2

➢ Income Policy- To manage inflation and ensure fair income distribution.

Schools of Thoughts in Macroeconomics

 Set by : MR. Tilahun W.

“In the long run we all are dead” – John Maynard Keynes

1. Classical School-1776-1870 (18th – 19th Century)

Influential Classical Economists Include:

✓ David Hume (1711-1776), Adam Smith (1723-90), Thomas Malthus (1766-1834), David

Ricardo (1772-1823), John Stuart Mill (1806-1873), Alfred Marshall (1842-1924) and Arthur

Pigou (1877-1959). 3

 The economy is self-regulating and always tends toward full employment.

 labor demand and labor supply are brought into equilibrium by the real wage. As a result,

there is no involuntary unemployment. (labor market)

 saving and investment are brought into equilibrium by the interest rate and investment

responds to the interest rate3(financial market)

 money demand is simply a transaction demand and money has no any effect on the real

economy and hence raising the money supply simply pushes up prices (i.e.

inflationary). That is what we call Classical dichotomy: the quantity of money affect only

nominal variables (i.e. money wages, and nominal GNP), and have no influence whatsoever on

the real variables of the economy such as real GNP, level of employment and real wage rate. 3

In general, for classical economists, both Fiscal policy and monetary policy are useless. Because,

for them;

➢ Fiscal policy raises interest rate and crowds out investment.

➢ Monetary policy raises prices and does nothing to “real” things3

Implication: No need for macroeconomic policy.

Government has no any role in the economy through its fiscal and monetary policy. As such

classical economists are advocates of “laissez-faire” –free market system.3

 Set by : MR. Tilahun W.

“In the long run we all are dead” – John Maynard Keynes

2. Neo-classical 1870–1936: Basically, the neoclassical school is not different from the classical

school. The main distinction is the tool of analysis, such as the marginal analysis. In the area of

growth theory, they gave us neoclassical growth models. Eg: Solow growth model.

 central working assumptions of the new classical school are:-

 Economic agents maximize. Households and firms make optimal decisions given all

available information in reaching decisions and that those decisions are the best possible

in the circumstances in which they find themselves.4

 Expectations are rational4:- imply that people will eventually come to understand

whatever government policy used, and thus that it is not possible to fool most of the

people all the time or even most of the time.

 Markets clear. There is no reason why firms or workers would not adjust wages or

prices if that would make them better off.4

3. Keynesian Macroeconomics (1936 – 1970s)

Influential Keynesian Economists Include:

✓ John Maynard Keynes (1883-1946), Paul Samuelson (1915-2009), James Tobin (1918-2002),

and Franco Modigliani (1918- 2003).4

❖ The self-correcting feature of the market, which is of course the hallmark of classical

theory, does not work. They believe that prices and especially wages respond slowly to changes

in supply and demand, resulting in shortages and surpluses,

❖ AD is influenced by a host of economic decisions – both public and private.

❖ Changes in AD, whether anticipated or unanticipated, has its greatest short-run impact on real

output and employment, not on prices.

 Set by : MR. Tilahun W.

“In the long run we all are dead” – John Maynard Keynes

❖ Keynesians are more concerned about combating unemployment than about conquering

inflation.

❖ Policy Implication

 During recessions, government should satisfy peoples demand for more cash preventing

the downward spiral of shrinking income and shrinking spending via monetary

expansion5

 During depression5fiscal expansion can break the vicious circle of low spending and low

incomes and getting the economy moving again.5

4. The Neo-Keynesian synthesis (1950s &1960s)

Influential Neo-Keynesian synthesis Include:

-5Paul Samuelson (1915-2009), James Tobin (1918-2002), Franco Modigliani (1918-2003),

Robert Solow (1924-) plus virtually all economists in 1950s and 1960s except Milton Friedman

(1912-2006).

The neo-Keynesian synthesis was developed by neoclassical economists who allowed the

economy for a short run behaviour with Keynesian properties and a long run with classical

5properties

For them the Economy is “Keynesian” in the short run but “Classical” in the long run.

Long-run AS curve is vertical while short-run AS curve is upward sloping55

-Combines rational expectations with sticky prices and wages.

-Accepts that markets don't always clear quickly.

-Justifies the use of monetary and sometimes fiscal policy.

-Policy Implication: Supports both fiscal and monetary policy to correct short-run fluctuations.

5.Monetarism (1970s)
 Set by : MR. Tilahun W.

“In the long run we all are dead” – John Maynard Keynes

Influential Monetarists Include:

 Milton Friedman (1912-2006), & Karl Brunner (1916- ), Allan Meltzer (1928-), & David

Laidler (1938-)

 depressions were the consequence of a temporary shortage of money and this implied that

monetary policy was of prime importance in determining the aggregate level of output

and employment.

 Emphasizes the role of money supply in influencing economic activity.

 Inflation is always a monetary phenomenon.

 Markets are generally stable; instability arises from poor monetary policy.

-Policy Implication: Control inflation through steady growth in the money supply; limit fiscal

intervention.