This document provides an introduction to macroeconomics. It defines macroeconomics, discusses key questions in the field, and outlines different schools of thought regarding the appropriate role of government intervention in the economy. The document also summarizes different economic goals and debates around activist versus non-activist policy approaches.

1. INTRODUCTION TO
MACROECONOMICS

2. WHAT IS MACROECONOMICS
 Macroeconomics
> is concerned with explaining the behavior of the
economy in the aggregate.
> seeks to identify the determinants of economic
variables such as output, output growth, inflation rate,
balance of payment, interest rates, unemployment, etc.
> attempts to explain the relationships among
these above-mentioned variables.

3. Key questions in macroeconomics
1. What determines economic growth?
2. How do we explain inflation?
3. How do we explain periods of high and persistent
unemployment?
4. What can government do in periods of
macroeconomic instability? Should it intervene?

4. AGREEMENT ON
MACROECONOMIC GOALS
 Increase in the range of good choices
 Increase in our freedom (of choice)
 Increase in our capability to deal with social problems
 Help achieve higher living standards and offers
possibility of a decent standard of living for all
citizens.
 Needed for full employment when population grows
and when labor productivity increases – because an
increase in productivity increases work and income.

5. ECONOMIC GOALS
 ECONOMIC FREEDOM
 ECONOMIC EFFICIENCY
 ECONOMIC STABILITY
 ECONOMIC SECURITY
 ECONOMIC GROWTH
 But… What is the most appropriate economic
goal?
ECONOMIC PROGRESS
DUE TO
FULL PRODUCTION
AND
FULL EMPLOYMENT

6. APPROPRIATE ECONOMIC GOAL
 Not the unattainable ideal of FULL EMPLOYMENT
but “the realistic objective of reducing the frequency,
length and severity of RECESSIONS.”
 What is recession?

7. THE BUSINESS CYCLE
DEPRESSION
RECOVERY
EXPANSION
PEAK/PROSPERITY/BOOM
SLOWDOWN
DECLINE
DEPRESSION
RECESSION
RECOVERY

8. SLOWDOWN
 Slight reduction of sales of goods and services.
 Inventories – the amount of unsold goods available –
will begin to increase, but only a little.
 Some workers who had been working overtime will
find themselves working fewer hours each week.
 Prices may not decline, but interest rates will tend to
fall a little.

9. DECLINE
 Output and sales of goods and services will decline.
 Many workers will find that they are no longer needed.
 Idle capacity will appear in the economy.
 Inventories will accumulate.
 Some inventories will be of goods ready for sale but
with no buyers appearing.
 Other goods will be partially finished with no need to
complete them.

10. DECLINE
 Some firms will have stocks of raw materials which
are not needed now for production.
 Prices may not decline, but there will be not much
of a tendency for them to rise either.
 Interest rates will fall since people will not be
inclined to borrow more money in the face of an
uncertain economic future.
 Debts will be repaid where possible, and some
people will attempt to save against the hard times
ahead.

11. DECLINE
 The decline or contraction will be rapid or slow. Once
it started, it tends to feed upon itself. As people lose
jobs and income they will buy less, which will lead to
declining production and put others out of work, who
will then buy less.
WHY IS THERE A DOWNTURN IN THE
ECONOMY?

12. NOTE
 If the decline persists, it is called a RECESSION.
 If recession becomes severe, lasting longer, sinking
deeper and causing greater misery, it is a
DEPRESSION.

13. ISSUES AND CONTROVERSIES IN
MACROECONOMICS
 Controversy: The disagreement stems mainly from
the role the government should play in achieving
objectives.
 Should the government intervene?
 What policy instruments or combination of policy
instruments should be used?
 Example: Should the government spend more in
periods when the level and/or growth of output is low
or during recession?

14. SCHOOLS OF THOUGHT
CONCENSUS
BIG POLICY DEBATE
ACTIVIST NONACTIVIST
JOHN MAYNARD
KEYNES AND HIS
FOLLOWERS
(KEYNESIAN)
NEW
CLASSICAL
ECONOMICS
MONETARISTS
SUPPLY – SIDE
ECONOMICS
Goals of growth, full employment, price stability, minimizing fluctuations
Using discretionary macropolicy

15. THE BIG POLICY DEBATE

16. ACTIVISTS
 Economists who think DISCRETIONARY (flexible,
optional, open, unrestricted) FISCAL AND
MONETARY POLICIES can and should be used to
achieve macroeconomic goals.
 REVIEW: What are our macroeconomic goals?
 “…when we suffer inflation or recession, government
should not just stand by and watch; government
should do something: use an active macroeconomic
policy.”

17. ACTIVISTS
 Ex: During Depression and Recession – expansionary
monetary policy ( Ms) & a fiscal stimulus to economic
growth of tax cuts ( T)or increases in government
spending ( G).
 People in-charge of macropolicy could make a bad
situation better by doing something rather than
abiding by fixed rules and waiting for long-term forces
to cure the problem.

18. NONACTIVISTS
 Economists who think discretionary fiscal and
monetary policies are useless or worse than useless.
 Milton Friedman: Mistakes in macropolicy destabilize
the economy – like cause of the Great Depression is
mistaken monetary policy, that is, drastic decline in
money supply caused by a wave of bank failures.

19. NONACTIVISTS
 EFFECTS: UNDESIRABLE TENDENCIES
1. INFLATIONARY BIAS
> tax cuts, spending increases, easy money
are highly popular. Politicians will tend to support these
policies.
> in contrast, the anti-inflationary policies
of tax increases, spending cuts, or tight money are
unpopular.

20. NONACTIVISTS
2. Special interest groups will gain power from
frequent use of discretionary policy.
WHY?
Because every tax or spending change offers an
opportunity for transfer-seeking activities.
RESULTS TO
Increasing influence upon Congress and
worsening of government failure.

21. HISTORY: CLASSICAL ECONOMICS
 ADAM SMITH: Book: “An Inquiry Into the Nature &
Causes of the Wealth of Nations (1776).
 Economics was mostly nonactivist and micro rather
than macro in focus.
 WHY?
 Because…

22. HISTORY: CLASSICAL ECONOMICS
1. Economic fluctuations are merely temporary and
self-correcting; hence they are nothing to worry
about.
2. All unemployment is voluntary because an
unemployed worker can always find a job by
accepting lower wages.
3. The free movement of prices, wages, and interest
rates is a fast and effective remedy for economic
fluctuations.

23. RESULT:
GREAT DEPRESSION OF THE
1930s!!!
CLASSICAL ECONOMICS could
not explain it!!!

24. HISTORY: KEYNESIAN ECONOMICS
 JOHN MAYNARD KEYNES – Book: The General
Theory of Employment, Interest and Money (1936).
 Cause of Great Depression was insufficient
aggregate demand: too little total spending.
 inadequate spending by consumers, businesses, and
government caused layoffs and mass unemployment,
which then led to still less purchasing power and
worsening depression.

25. HISTORY: KEYNESIAN ECONOMICS
 Causes of economic fluctuations are choices by
business people regarding investments in inventories,
buildings, and equipment.
 If total spending by consumers and business firms is
not enough to support a full employment level of GDP,
government should either SPEND MORE or TAX
LESS to stimulate aggregate demand (discretionary
fiscal policy).
 CB use discretionary monetary policy to ease credit
and thereby stimulate spending through an increase in
borrowing and lending.

26. VICIOUS CYCLE IN KEYNESIAN MODEL TO
CAUSE LONG-LASTING DEPRESSION
Gloomy
Expectations of
Business People
for Profits
Downturn in
Business Spending
for inventories,
plant & equipment
Lower GDP & Lower
Income
More worker layoffs,
hours cut back, less
new hiring
Lower Consumer
Spending
Lower Sales, losses or
lower business profits
LEAD TO A
CAUSES
AS SPENDING FALLS
DUE TO LOWER
INCOMES
RESULTS IN STILL
LOWER INCOMES
FOR HOUSEHOLD
AND HENCE
LEADS TO
ADD TO

27. MONETARISTS
 Non-activists who think economic fluctuations result from
the CB’s mistakes in monetary policy – the only way to
make good monetary choices is to follow a rule for a slow,
steady growth in the money supply.
 Discretionary fiscal policy has little or no effect and it is the
cause of instability not a cure – cause of inflation and
recession.
 Therefore, oppose discretionary monetary policy.
 Depression is the result of an accumulation of mistakes by
the CB which allowed widespread bank failures which
caused a drastic reduction in the money supply.

28. MONETARISTS
 Discretionary monetary policy choices by the CB are
likely to worsen economic fluctuations rather than to
smooth them out.
 Inflation is caused by too much money and that
recessions are worsened by too little money!
 To achieve the twin goals of steady growth and stable
prices: Expand the money supply at a constant
rate about equal to the long-term rate of growth
in real GDP.

29. CONCENSUS BETWEEN MONETARY
AND FISCAL POLICIES
 MONEY MATTERS – stable relationship between GDP
growth and the growth in money supply (MS).
 TIME LAGS in limiting the effectiveness of monetary
policy.
 Government-guaranteed insurance of bank deposits,
reduced the probability of financial panics (bank
runs).

30. CONCENSUS BETWEEN MONETARY
AND FISCAL POLICY
 Automatic fiscal stabilizers tend to reduce the severity
of recessions (weapon against recession) but not an
effective weapon to fight inflation because it is so hard
to get tax increases or spending cuts through Congress.
 Fighting depression with monetary policy – nobody
can force people to borrow – firms and consumers are
pessimistic.

31. SUPPLY-SIDE ECONOMICS
 Also called “VOODOO ECONOMICS”, advocates
policies of tax cuts and deregulation to increase
economic growth.
 PREMISES:
> fluctuations in total spending (aggregate
demand) are not a problem.
> tax cuts and deregulation are the only
prescriptions needed to stimulate output, balance the
budget to achieve prosperity.

32. NEW CLASSICAL ECONOMICS
 Adds the premise of “rational expectations.”
 States that people will change their expectations to take
into account of discretionary macropolicy actions.
 Causes people to act in their own self-interests to protect
themselves from or to take advantage of policy actions.
 “People do exactly the opposite of what policy makers want
them to do.”
 Inflation: monetary policy expectation: Tighten up
money and credit (restrictive) – incentive to borrow and
spend immediately because of low interest and before
restrictive monetary policy goes into effect.

33. SUMMARY
SCHOOLS OF THOUGHT
 Classical/Neo Classical School
> markets work best when left alone
> money matters
 Keynesian
> emphasizes the role of activist government
policy

34. SUMMARY
SCHOOLS OF THOUGHT
 New Classical School
> Argues that individuals act rationally in their
self interest in markets that adjust rapidly to changing
conditions. The government …. is only likely to make
things worse by intervening.
> Key assumptions: optimizing agents,
expectations are formed rationally, all markets clear

35. SUMMARY
SCHOOLS OF THOUGHT
 New Keynesian School
>Argues that, even if individuals act rationally,
there is room for government intervention since
markets do not always clear. The non-clearing of
markets may be due to informational problems or
costs of changing prices.