2. What is Macroeconomics?
Macroeconomics is an aggregate economics that deals with
2. performance and
3. behaviour of the economy as a whole.
The prime concerns are
4. Investment, saving, consumption, and
5. International transactions and the like.
Macroeconomic analysis seeks to explain:
1. The cause and impact of short-run fluctuations in GDP
(the business cycle), and
2. The major determinants of the long-run path of GDP
3. Why Macroeconomics and How it works?
1. It is important for having sustainable development
2. It influences the lives and welfare of all through
• Monetary Policy: Regulation of money supply with the following
specific issues: (Money supply, interest rate, inflation rate, credit,
foreign exchange rate, financial development, and the like)
• Fiscal Policy: regulation of government account with respect to
taxation policy (direct tax, indirect tax and trade tax) and
expenditure policy (Recurrent expenditure, and capital expenditure).
It is also associated with fiscal deficit and debt accumulation
3. Policy Goal, Policy Objective, Policy indicators, Policy
target and policy tools. Question1: How can we design them
and what are the criteria for setting them? How do they work in a
very harnessed way?
What macroeconomists believe today is the result of an evolutionary
process in which they have eliminated those ideas that failed and kept
those that appear to explain reality well.” Blanchard (1997)
History of Macroeconomics can be divided or evolved in three epochs:
1. Pre 1940: a Period of Exploration
2. 1940-1980: A Period of Consolidation
3. Since 1980: A new Period of Exploration
4. The Birth of Macroeconomics: Great Depression
• Great Depression is one of the great and misunderstood even in the history of
America. The Great Depression was a worldwide event. By 1929, the world suffered a
major rise in unemployment.
• The Great Depression was not the country’s first depression, though it proved to be
the longest and most severe.
Many did not realize how severe the downturn was until 1932, when the economy
had technically “hit bottom”. There are several explanations, but the most obvious
causes are four:
1. Overproduction and under consumption: high demand for consumer goods and agricultural
products led to overproduction and then under consumed.
2. Banking & Money Policies : Banking policy offered “ buying on credit” first with lower interest
rates, causing dangerous situation. As demand fall behind supply, borrowers were not able to
pay. Buying on credit increased personal debt, and higher interest rates, caused less demand
3. Stock Market Actions : As business was booming in the 1920s and stock prices kept rising
with businesses’ growing profits. The extensive speculation that took place
in the late 1920s kept stock prices high, but the balloon was due to burst. With the loss of
confidence in stocks, people began to lose confidence in the security of their money being held
in banks. Customers raced to their banks to withdraw their savings.
4. Political decisions: Because of poor advice from experts, Hoover did take action to intervene
in the economy, but it was too little too late. Officials believed that raising trade barriers would
force Americans to buy more goods at home, which would keep Americans employed. But
they ignored the principle of international trade- it is a two-way street; If foreigners can’t sell
their goods here, they will shut off our exports there!
5. This Great Depression created a daunting challenges for the existed
classical economics thinking which prevalently controlled the world
since 17th century.
Given this economic events, However, a methodological contribution
made by Keynes bring a crucial difference against what was before .
1. Keynes explicitly considers three markets (goods, financial, and
labour) in his analysis.
2. Using goods market equilibrium, he showed how shifts in saving
and investment led to movement in output.
3. Using both goods and financial market equilibrium, he showed
how various factors affected natural interest rate (called
marginal efficiency of capital), money interest rate, and out put.
6. Major Schools in Macroeconomics:
1. Classical Economists
4. New classical economists
5. Real Business Cycle
6. New Keynesians
7. 1) Classical Economists
• Names that springs to minds are: Adam Smith, David Hume, David
Ricardo, John Stuart Mill, Knut Wicksell, Irving Fisher, Alfred
Marshall, Arthur Pigou.
• It was more of microeconomics period- 17th century to 1930. It
was a period during which Western Europe and USA experienced
Reformation(related with objection to Catholic practices) and
Enlightenment(a philosophical movement in reasoning).
• They were attaching and successfully refuting mercantilist
doctrine (that states wealth and power of a nation determined by
precious metals, along with government intervention)
• Classical economics did not have a macroeconomic theory, but
their idea could be interpreted in a macroeconomic framework.
• They focused on real rather than financial assets.
8. • Classical economists argues that markets would act to co-ordinate people’s plans (Adam
smith invisible hand) and set the followings:
1. The invisible hands is captured by Jean-Batiste Say law “supply creates its own
2.Aggregate Supply: Outputs are determined by factors of production, not by demand
and produced at natural rate. Factors are also employed fully /Full employment
Assumption/ and Aggregate supply curve is vertical.
3. Aggregate Demand: it is an implicit theory of AD, Classical aggregate demand can be
derived from quantity theory as follows:
4.Money is considered as a medium of exchange and then money demand is
proportional to nominal income. Velocity of money is treated as constant.
5. Prices and wages are flexible. They are fully and quickly adjust to economic changes-
gaps in supply and demand.
6. If money supply increases, it leads to increase in AD. But, price increase to restore
equilibrium, without affecting real sector, following a story of “ too money chasing
too few goods”. Money Neutrality or Dichotomy of the economy
7. Equilibrium Interest rate: Price level and output level are determined independently
of the interest rate as excluded from the AD-AS equation. But, they believe that
interest rate is important to stabilize aggregate demand. They believe that Interest
rate is determined in the market for loanable funds, in today’s language it is credit
8. Money supply change do no affect current output and only affect the price level.
Change in government expenditure have no effect on current output and only affect
interest rate, and the amount of investment and consumption undertaken. It also
creates crowding out effect
9. 2) Orthodox Keynesians
• Keynesian economics challenged the dominance of classical economics and
led to macroeconomics as branch of economics. The major work of Keynes
was “ The General Theory of employment, Interest and Money”, published
1.The classical economists could not explain the short-run fluctuation
such as Great Depression. Keynesian theory is based on the income-
expenditure model and IS-LM model
2.Keynesian Money demand Model: Keynes’ liquidity preference theory
that focuses on the three motives behind money demand: Transaction
Motive, Precautionary Motive and Speculative Motive. There is only
two assets that constitute wealth.
3. Keynes introduced a monetary theory of interest rates, as opposed to
the real theory of interest rates in the Classical system.
4. Keynes introduced the idea that money can be held as an asset—as a
store of value. This is his speculative demand
5. Unlike Classical theory, the Velocity in Keynesian theory is not
constant but fluctuates with interest rates.
( , )
f Y i
( , )
PY Y Y
M f Y i
10. 6. Aggregate Demand: It consists of the sum of consumption, investment,
government purchase, and net export. It concludes that AD is unstable and can
be affected by a number of factors (i.e. business & consumer confidence). It
gives money an important but lesser role in the determination of AD & prices.
7. Reasons why fiscal policy is more potent:
• Change in monetary condition had little impacts on interest rate:
• The Liquidity trap: Some Keynesian thought that at low interest rates that
changes in money stock would have little if any effect on interest rate. It is
argued that at low interest rate people would be willing to hold the extra
money without a further decrease in interest rate, because people must
believe that interest rates can only increase
8 Keynesian believed that the causes of this Depression was due to a combination
of events that led to a great uncertainty, decrease in investment, unemployment
trap. During the 1920s , a great boom uncertainty in many countries, but a great
uncertainty arose over the future due to the change:
• Changing trading patterns due to the relative decline of the UK as an
economic powerhouse, and the rise of countries such as Japan and
• Increase international currency fluctuations
• Increasing use of restrictive trading practices regarding international trade,
essentially to prevent adjustment to the change that was occurring.
• Doubt about the stability of the international financial system related to
reparation required of Germany following World War I.
11. 9 If interest rates increase, then people who hold assets other than money
will experience a fall in their price and will thus make capital losses.
• A liquidity trap is a situation described in Keynesian economics in which injections of
cash into the private banking system by a central bank fail to lower interest rate and
hence make monetary policy ineffective. A liquidity trap is caused when people hoard
cash because they expect an adverse event. Common characteristics of a liquidity
trap are interest rates that are close to zero and fluctuations in the money supply that
fail to translate into fluctuations in price levels. So the link between M and I broken
12. 10. Investment was relatively insensitive to change in the interest rate:
• According to Keynes, change in monetary condition had little impact on
investment. He believed that the main influencing factor on investment
is business expectation about future profitability.
• This expectation were subject to animal spirits-large change with no
• As a result, the link between change in interest rate and investment is
11. Aggregate Supply:
• Keynes stated that in short run that market did not work as posited by
Classical economists. And, he argues wage and quantity did not adjust
where there is excess supply of labor, involuntary unemployment
• He believed that Say’s Law did not hold. This is due to the fact that the
decision to sell are not automatically transformed into a decision to buy
as sales has first realized before a purchase can be made. Its analogy is “
chicken and egg” .
• Inflexible price, sticky price. It implies for change in real wage.
• Factors of production are not fully employed.
• Aggregate supply curve is horizontal, as price is fixed in the short run
and is determined by aggregate demand. This seems opposite to Say’s
Law- demand seems to cause its own supply.
13. V. Later work on Keynesian Money demand
A) Problem with the Speculative Demand For Money:
• There were problems with basing the relationship between money demand &
interest rates on Keynes’ speculative demand:
• The implication of the speculative demand argument is that people will either
hold all bonds or all money with no diversification. This was a serious short-
coming. The very existence of the speculative demand is questionable
• These problems prompted later efforts to explain money demand as a function of
interest rates without relying on the questionable speculative demand.
B) The Baumol-Tobin Model of the Transactions Demand for Money :
• William Baumol & James Tobin, independently developed models of money
demand in which the transactions demand for money is sensitive to the interest
• People have an incentive to economize on transaction money balances when
interest rates rise, thus: the increase in interest rate causes lost income due to
holding money to get high. Money demand decrease in response.
• Similar models of precautionary demand produced a similar tradeoff between
additional income versus convenience of precautionary balances
3. The Tobin Model of the Speculative Demand for Money
• A second Tobin model introduced risk and assumed that people want high
returns but are risk averse. If bonds have risk, even at high interest rates people
will always hold some money.
• A problem with the second Tobin model, in addition to the fact that the
speculative demand may not exist:
• There are assets that have virtually no risk (T-bills, money market mutual funds)
but have a higher return than money.
14. Monetarist Macroeconomics
• Keynesian economics was the dominant macroeconomics until 1950s.
Influential monetarist economists included: Milton Friedman, Karl Brunner,
Allan Meltzer, and David Laidler.
• The impetus for monetarism did not seem to be due to an external
event, like Keynesian.
• It came in two waves: First, mid 1950s to mid 1960s, and second mid
1960s to mid 1970s.
• It originated with Friedman who attempted to revive the quantity
theory of money.
• He rejects Keynesian View that money had little or no impacts on
output and employment.
• The first wave was not a rejection of the IS-LM , but a debate the actual
values of the parameters of the model.
• There were also disagreements, particularly in the second wave, about
policy issues that really could not be addressed in IS-LM.
15. 1. Importance of Money: Friedman carried this influential work with Anna
Schwartz, entitled “ A Monetary History of the United States 1867-1960”.
They found the following patterns:
1. The money stock tended to rise during contractions and expansions, but
the rate of money growth slowed during contractions.
2. The only times that major economic contractions occurred were when
the absolute value of the money stock fell (i.e. money growth was
3. Change in Money causes changes in Money Income
4. The main finding is that money is more important in explaining change in
money income than fiscal conditions. It led to the acceptance of the
importance of monetary policy by Keynesian, although they disagreed
with Monetarist about other things.
2. The Demand for Money: The main reason why the Monetarists study money
demand is that Keynesian believed that the money demand was instable so that
they conclude there was no use for monetary policy as its effects would be
1. Monetarists shows that demand for money was stable, would overturn
the result of Keynesian.
2. The starting point for Friedman was the quantity theory of money:
MV=PY, and in equilibrium:
3. Since P and Y do not usually “jump around”, any instability in Money
demand must be from instability in V from things such as change in r
(which determine the opportunity cost of holding money), which was
exactly what the Keynesians argued, that the demand for money was un
stable because the transaction velocity of money demand was unstable.
( , , )
M M M V P Y
16. • To see whether or not the demand for money was unstable, Friedman, and
then Laidler, set about estimating the demand for money using economic
data and some statistical techniques.
• Friedman posited that the demand for money could be written as:
• Where is permanent income, which is used as a proxy for wealth and
captures the transactions demand for money and portfolio allocation of
• r is return on financial assets and captures the opportunity cost of not
holding other assets
• is the expected rate of inflation and capture the loss in the value of
money, a nominal assets, from inflation
• u is individual’s taste and preference, and just reflects that people are
( , , , ) ( )( )( )(?)
f P r Y u
17. There are two reasons that r enters the demand for money negatively:
1. Opportunity cost: if r is low then the opportunity cost of holding money is low, V is
low and the demand for money is relatively high.
2. Trade Credit: if r is low then the use of trade credit is high, V is low, and the
demand for money is relatively high ( as liquid forms of credit, such as trade credit,
are part of money supply).
Monetarist said that money was a substitute for a wide range of real and financial
assets, but that no single asset could be considered a close substitute for money. From
their thinking, monetarists hypothesized that change in r could affect money demand,
that the affects were likely to be small, and probably positive. Theሀ believed that fiscal
policy would lead to a large amount of crowding-out of investment, and little impact on
output in short term.
• Money demand functions were estimated and it was found that:
1. The interest rate was significant in affecting money demand. This means that the
LM curve is not vertical and thus probably affected by V.
2. The interest elasticity of money demand does not seem to increase as the interest
rate falls. Thus, no liquidity trap and so the LM curve is not horizontal.
• The money demand function was found to be stable till the1970s after which it appeared
unstable for many countries. This coincides with the breakdown of the then existing
international monetary system ( the Bretton-Woods fixed exchange rate system when the
value of the currency were fixed to the US dollar, the value of which was fixed in terms of
• This event led to many currencies floating and to innovation in financial instruments. In
any event, at the time of Friedman, and until after the 1970s, the demand for money
function was found to be stable.
18. Explaining The Depression
Friedman and Schwartz argued that a mild contraction in money stock from
1929 to 1930 was converted into a sharp decline by a wave of bank failures
starting in later 1930. The Bank failures caused:
1. Increase in the reserve ratio of banks
2. Increase in cash drain
Both effect were exaggerated by a high degree of economic uncertainty and
caused a large fall in the money multipliers.
• Monetarists assumed that the interest rate sensitivity of investment is very high
so that the IS curve is very flat. Consequently, fiscal policy leads to strong
crowding out of private investment.
• Like Classical, they had strong sympathy for the quantity theory of money which
implies a steep or vertical LM curve.
• Unlike Classicalist, Friedman does not accept the REH, instead, he adopted the
• Fiscal policy is unable to influence employment and output in monetarism,
• Monetary policy has a real effect. Considering quantity theory, the distribution
of total effect over real effects and nominal effects depends on the assumptions
made about the labour market and the formation of expectation.
19. • Under AEH, there are temporary effects on real output. Therefore, the
policy makers may be tempted to use a monetary expansion to combat
• However, policy makers not very good at timing monetary policy due to lag
structures and its effect on effectiveness on monetary policy.
• As a result, monetary policy can accentuate business cycle fluctuations in
economy. That is why Friedman suggests the Central bank should follow a
constant growth rule for some monetary aggregates and not tinker with
monetary policy in order to try to influence aggregate demand and
• Policy Rules: They argues that it is optimal for authority to follow rules for
monetary aggregates to ensures long-run price stability. They also argued
fiscal policy could only be used to influence the distribution of income and
wealth, and the allocation of resources.
• They argues that the only way to increase output permanently was to
make market work better.
• The profoundest effect was that they opened the door to the fact that
macroeconomics is not able to be adequately captured by a static model
because dynamic are important in particular: expectations and growth rate
are about change of variables over time.
20. Summary of Monetarism
• Importance of the quantity of money stock: Monetary policy is the
predominant policy tool, whereas fiscal policy was seen unimportant.
• Inflation and the Balance of payment are essential monetary phenomena:
Inflation is a monetary phenomenon. The amount of money in circulation
and inflation have an impact on exchange rate, imports, exports.
• No long-run trade-off between inflation and unemployment: The speed of
adjustment is relatively quick for monetarism, but slow for Keynesian.
• Stable Macroeconomics: Monetarist believed government is the main
source if shocks. The economy is inherently stable unless distributed by
erratic money growth. They believed the market system was not perfect,
but government made worse. As they said, depression was a bad
recession, turned into a bad depression due to bad government monetary
21. 5) New Classical Macroeconomics
Monetarism and Keynesian battled it out until the early 1970s, after which a
combination of two things were to lead their demise as the main school of thought.
The successors, new classicalist, shared a lot of ideas of the monetarists.
Influential economists include: Robert Lucas, Neil Wallace, Thomas Sargent and Robert
New Classical economics was initiated by Robert Lucas and arose for two reasons:
1. Theoretical: Introspection and a dislike for the monetarist and Keynesian
2. empirical: inconsistencies between Keynesian and Monetarist models and what
actually happened in the late 1970s resulting from oil price shocks
Stagflation and aggregate supply:
1. The Phillips curve found in 1958 and more elaborated in the 1960s seemed to
promise to have stable trade-off between unemployment and inflation rate.
2. However, the experience of the late 1960s and 1970s blew this relationship
apart. During this period most economies experienced both high inflation and
high unemployment-stagflation. The magnitude of the change in unemployment
seemed very large as compared to the size of change in inflation.
3. A single short-run Phillips curve would have trouble in explaining these
movement, hence expectations augmented Phillips curve.
4. Some economists argued that the size of these changes seemed inconsistent
with adaptive expectations, which implied that people would adjust their
expectations slowly over time. This means that larger changes will cause larger
errors and therefore larger adjustment in expectations.
22. • Some economists still thought that the movement were much larger than could be
explained by this sort of argument.
• Finally, the shock to the World economies that seemed to cause this changes in the late
1970s were not the standard run-of-the-mill shocks that people were used to.
• The oil-price shocks are the main ones, but there were other shocks for the other countries.
Notice that these were not changes in investment demands, nor in fiscal and monetarist
• These were changes that affected the production of output, they were shocks to the AS
curve. Till this time, economists had really just focused on AG since the Great Depression and
Keynes, and the event of the 1970s caused economists to think once again about the supply
side of an economy.
In Summary, the following occurred:
1. Unemployment and inflation were equally likely to change in the same direction as
the opposite direction, it means that there is not trade-off.
2. The change in inflation, unemployment and output were a lot larger than predicted by
adaptive expectation theories and models.
3. The economic shock that were occurring were not the normal type, it is AG shocks.
4. The IS-LM/AS-AD and PC could not capture all of these phenomena.
On top of these, the New Classicalists were unhappy in macroeconomic theories for 3
1. The type of shocks were different from the past
2. Macro models did not have microeconomic foundation
3. The method used to think about how people thought about future when they were
making decision seemed inherently inconsistent.
23. • Summary of the New Classical Economics:
1.Expectations are formed rationally.
2.Markets continuously clear.
3.Short-run aggregate supply is upward sloping as they have
imperfect information in the short-run
4.Long-run aggregate supply is Vertical as they have perfect
information in the long-run.
• Implications of New Classical Macroeconomics:
1.Real output and employment are unaffected by systematic and
therefore predictable, changes in aggregate demand.
• They are called Fresh water economists, because they work at
Universities near the big lake in the mid west (Chicago, Carnegie-
Mellon, Minneapolis) in contrast to Keynesian, Salt water economics
from universities on the East Coast( Harvard, MIT, Yale, Pinceton)
• They stress mathematical techniques and they have shed themselves
more thoroughly of the neo-keynesian synthesis than the monetarist,
and firmly back classical ideas such as flexible prices and wages,
rational expectations or perfect foresight, efficient of market, full
• All fluctuations are due not to nominal rigidities, but to rational
agents responding to the incentives as they observe them.
24. 6) REAL Business cycle macroeconomics
Influential RBC economists include: Ed Prescott, and Charles Plosser. While New
Classicalist revolutionized macroeconomics by introducing rational expectation, it had
trouble in explaining an empirical facts.
This was that deviation from capacity output (recession and expansions.) tended to be
prolonged and correlated, or in the same direction. New Classical economics implied
that such deviation should be short-lived and random in direction.
• One of the explanation was that there were informational time lags, that it took
several periods in the future before people would fully learn what had happened
• Many people found this to have a ring of truth to it, but not to be able to explain
the magnitude and length of some recessions and expansions.
• Further, the AD-AS model was static in nature and missed out all this inter-
temporal behaviors so it was an inappropriate tools to use to think about
economic behaviors of several years.
• This gave rise to the real business cycle theory of economic fluctuations.
• A lot of this work is computationally very intensive and it just happened to coincide
with the advances in cheap personal computing power in the 1980s.
• Summary: Expectations are formed rationally, Markets are always clearing, Money is
neutral, Economic fluctuations are due to only to supply Side factors like change in the
rate of technological change, natural disasters, good growing seasons, tax rates, input
price changes, changes to incentives from things like social welfare program.
• In first wave: What holds classical school holds for the RBC. BUT some difference: there
is no real concept of AD in the IS-LM in RBC, BUT there is in the classical theory. But have
• In second Wave: it includes market imperfections on the supply sides.
25. 6.1 Random Walks
• The key empirical fact that gave rise to the RBC school was the
finding that shock to USA output changed the path of output over
• In technical terms, this is to say that output exhibited a random
walk, i.e. diverting from its trend.
• Since output did not revert back to its trend, shocks to output could
not be result from monetary sources, but must be from real sources,
hence the view that business cycle are caused by real shocks.
6.2 Inter-temporal Substitution
• The major question this behaviors is how do such shocks result in
prolonged correlations of deviations of output from trend? The key is
how the shocks (or impulses) are transmitted or propagated in the
• For RBC theories, this involves explicitly acknowledging that an
economy is inter-temporal in nature and that shocks have impacts
• For instance, technological shocks affect the economy through:
labour market, saving and investment, output tomorrow.
26. 7. New Keynesian Macroeconomics
• At the same times as RBC theories emerging, so too was another set of
theories. This was an attempts to reincarnate earlier thoughts, but dressed up
with in the new classical framework.
• The underlying points of disagreement were of an empirical nature. Influential
New Keynesians include: Edmund Phelps, Greg Mankiw and David Romer.
• While the new classical and RBC schools assumed clearing markets, it appeared
to some economists that in recessions some people who were unemployed did
not want to be. On the other hand, they had no convincing reason as to why
there should be “ involuntary unemployment” .
• This lead several people to sit down and have a think. Their basic goal was to
see if they could come up with a model with agents forming their expectation
rationally, which had good ties with microeconomics but in which
unemployment could occur and in which changes in the money supply had an
• They derived their inspiration from the insight of Keynes. Market may not be
as perfect as the classical suggest
• Early New Keynesian accepted the REH, but stressed the existence of nominal
rigidities. Arising from multi-period nominal wage contracts. Such rigidity
invalidates the PIP of the new classical economists.
• Hence, new Keynesians argue that the government can and should stabilize the
economy even under REH.
• The most recent wave of new Keynesian economics is more micro-based. The
predominance of imperfect competition, coordination failures, credit restriction
are stressed. 26
27. • Price and WAGE RIGIDITIES: New Keynesian have suggested several possible reasons as to
why changes in the money supply and other changes to aggregate demand may have real
effects, as well as supply side shocks.
1. Efficiency wage,
2. Insider-outsider union models
3. Contracts and the staggering of price and wage changes
4. Menu costs and imperfect competition
• As with the RBC , the AS-AD model does not capture many of the feature of new classical
though. This is not helped by the fact that there is no general new Keynesian theories at
• Summary of New Keynesian School: Market imperfections exists, prices an wages are
sticky in the short run, Money is non-neutral, and AS shocks are important.
Final Summary Regarding Macroeconomics Thought
• Macroeconomics in general has evolved two ways:
1.Individuals’ Innovations: in many cases, macroeconomic thought has changes due to
the thinking of isolated individuals, who come up with different ideas and facts.
Examples are Friedman , RBC and New Keynesian theories. These are scientific
research based approach and tend to lead challenges to an existing school of
thought, but within the existing framework.
2. External Shocks: macro thoughts has changed due to the challenging of the status
quo by external. Examples are enlightenment (cultural) and classical economics, or
price shock and new classical economics.
• Battle between two basic opposing ideas. Macroeconomics thought evolves over time