Chapter 1

Introduction to Macroeconomics
BEEB2023 Macroeconomics
University Utara Malaysia

Introduction to Macroeconomics
Microeconomics examines the behavior of individual
decision-making unitsbusiness firms and households.
Macroeconomics deals with the economy as a whole; it
examines the behavior of economic aggregates such as
aggregate income, consumption, investment, and the
overall level of prices.
Aggregate behavior refers to the behavior of all households
and firms together.

What Macroeconomics is About

Macroeconomics is the study of the
structure and performance of national
economies and of the policies that
governments use to try to affect economic
performance.

The Roots of Macroeconomics

(1)
The Great Depression was a period of
severe economic contraction and high
unemployment that began in 1929 and
continued throughout the 1930s.

The Roots of Macroeconomics

(2)
Classical economists applied
microeconomic models, or market
clearing models, to economy-wide
problems.
However, simple classical models failed to
explain the prolonged existence of high
unemployment during the Great
Depression. This provided the impetus for
the development of macroeconomics.

The Roots of Macroeconomics

(3)
In 1936, John Maynard Keynes published The
General Theory of Employment, Interest, and
Money.
Keynes believed governments could intervene in
the economy and affect the level of output and
employment.
During periods of low private demand, the
government can stimulate aggregate demand to
lift the economy out of recession.

Macroeconomic Concerns
Three of the major concerns of
macroeconomics are:
Inflation
Unemployment
Output growth

1: Inflation and Deflation

Inflation is an increase in the overall price level.
Hyperinflation is a period of very rapid
increases in the overall price level.
Hyperinflations are rare, but have been used to
study the costs and consequences of even
moderate inflation.
Deflation is a decrease in the overall price level.
Prolonged periods of deflation can be just as
damaging for the economy as sustained inflation.

Inflation
When prices of most goods and
services are rising over time it is
inflation. When they are falling it is
deflation.
The inflation rate is the percentage
increase in the average level of prices.

The inflation rate

Definition: rate at which the price level
increases
Measured
By GDP deflator = nominal GDP / real GDP
By CPI or Consumer Price Index

GDP deflator can be calculated by methods

similar to those developed for the
calculation of real GDP

Calculation of GDP deflator

Thatis:therateofinflationis18%

CPI or Consumer Price Index

Based on cost in $ of a fixed basket of
goods and services consumed by an
average urban consumer

Effects of Inflation
When the inflation rate reaches an
extremely high level the economy tends to
function poorly. The purchasing power of
money erodes quickly, which forces
people to spend their money as soon as
they receive it.

2: Output Growth:
Short Run and Long Run (1)
The business cycle is the cycle of shortterm ups and downs in the economy.
The main measure of how an economy is
doing is aggregate output:
Aggregate output is the total quantity of
goods and services produced in an economy
in a given period.

Expansion and Contraction:

The Business Cycle
An expansion, or boom, is
the period in the business
cycle from a trough up to a
peak, during which output
and employment rise.
A contraction, recession,
or slump is the period in
the business cycle from a
peak down to a trough,
during which output and
employment fall.

Output Growth:
Short Run and Long Run (2)
A recession is a period during which aggregate
output declines. Two consecutive quarters of
decrease in output signal a recession.
A prolonged and deep recession becomes a
depression.
Policy makers attempt not only to smooth
fluctuations in output during a business cycle but
also to increase the growth rate of output in the
long-run.

3: Unemployment
The unemployment rate is the
percentage of the labor force that is
unemployed.
The unemployment rate is a key indicator
of the economys health.
The existence of unemployment seems to
imply that the aggregate labor market is
not in equilibrium. Why do labor markets
not clear when other markets do?

Unemployment rate u
L=N+U
L is labor force
N is number of employed
U is number of unemployed

u = U/L
u is rate of unemployment

Data gathered by Department of Statistics

Current Population Survey

Government in the
Macroeconomics
There are three kinds of policy that the
government has used to influence the
macroeconomic:
1. Fiscal policy
2. Monetary policy
3. Growth or supply-side policies

Government in the
Macroeconomy
Fiscal policy refers to government
policies concerning taxes and spending.
Monetary policy consists of tools used by
the Federal Reserve to control the quantity
of money in the economy.
Growth policies are government policies
that focus on stimulating aggregate supply
instead of aggregate demand.

The Three Market Arenas (1)

Households, firms, the government, and
the rest of the world all interact in three
different market arenas:
1. Goods-and-services market [IS]
2. Labor market [AS]
3. Money (financial) market [LM]

[AD]

The Three Market Arenas (2)

Households and the government purchase goods and
services (demand) from firms in the goods-and
services market, and firms supply to the goods and
services market.
In the labor market, firms and government purchase
(demand) labor from households (supply).
The total supply of labor in the economy depends on the sum of
decisions made by households.

The Three Market Arenas (3)

In the money marketsometimes called the financial
markethouseholds purchase stocks and bonds from
firms.
Households supply funds to this market in the expectation of
earning income, and also demand (borrow) funds from this
market.
Firms, government, and the rest of the world also engage in
borrowing and lending, coordinated by financial institutions.

Issues Addressed by
Macroeconomists
What determines a nations long-run
economic growth?
What causes a nations economic
activity to fluctuate?
What causes unemployment?

Issues Addressed by
Macroeconomists (continued)
What causes prices to rise?
How does being a part of a global
economic system affect nations
economies?
Can government policies be used to
improve economic performance?

Long-Run Economic Growth

Rich nations have experienced
extended periods of rapid economic
growth.
Poor nations either have never
experienced them or economic
growth was offset by economic
decline.

Increased Output
Total output is increasing because of
increasing population, i.e. the number
of available workers.
Increasing average labour productivity:
the amount of output produced per
unit of labour input.

Rates of Growth of Output

Rates of growth of output (or output per
worker) are determined by:
rates of saving and investment;
rates of technological change;
rates of change in other factors.

Business Cycles
Business cycles are short-run
contractions and expansions of
economic activity.
The most volatile period in the history
of Canadian output was between 1914
and 1945.

Recessions
Recession is the downward phase of a
business cycle when national output is
falling or growing slowly.
Hard times for many people
A major political concern

Unemployment
Recessions are usually accompanied
by high unemployment: the number of
people who are available for work and
are actively seeking it but cannot find
jobs.

Unemployed
Unemployme nt Rate
100%
Labour Force

The International Economy

An economy which has extensive trading
and financial relationships with other
national economies is an open economy.
An economy with no relationships is a
closed economy.

Exports and Imports

Canadian exports are goods and services
produced in Canada and consumed
abroad.
Canadian imports are goods and services
produced abroad and consumed in
Canada.

Trade Imbalances
Trade imbalances (trade surplus and
deficit) affect output and employment.
Trade surplus: exports exceed imports.
Trade deficit: imports exceed exports.

The Exchange Rate

The trade balance is affected by the
exchange rate: the amount of Malaysia
Ringgit that can be purchased with a unit
of foreign currency.

Macroeconomic Policy
A nations economic performance
depends on:
natural and human resources;
capital stock;
technology
economic choices made by citizens;
macroeconomic policies of the government.

Macroeconomic Policy
(continued)
Macroeconomic policies:
Fiscal policy: government spending and
taxation at different government levels.
Monetary policy: the central banks control of
short-term interest rates and the money
supply.

Budget Deficits
The economy is affected when there are
large budget deficits: the excess of
government spending over tax collection.

Budget Deficits (continued)

The large budget deficits of the 1980s
and early 1990s are unusual.
Borrowing from the public might divert
funds from more productive uses.
Federal budget deficits might be linked to
the decline in productivity growth.

Aggregation
Macroeconomists ignore distinctions
between individual product markets and
focus on national totals.
The process of summing individual
economic variables to obtain
economywide totals is called aggregation.

What Macroeconomists Do

Macroeconomic forecasting
Macroeconomic analysis
Macroeconomic research
Data development

Macroeconomic Forecasting
Macroeconomic forecasting
prediction of future economic trends has some success in the short run. In
the long run too many factors are
highly uncertain.

Macroeconomic Analysis
Macroeconomic analysis - analyzing and
interpreting events as they happen helps
both private sector and public
policymaking.

Macroeconomic Research
Macroeconomic research - trying to
understand the structure of the economy
in general forms the basis for
macroeconomic analysis and forecasting.

Economic Theory
Economic theory: a set of ideas about
the economy to be organized in a
logical framework.
Economic model: a simplified
description of some aspects of the
economy.

Developing and Testing a

Theory

State the research question.

Make provisional assumptions.
Work out the implications of the theory.
Conduct an empirical analysis.
Evaluate the results.

Data Development
Macroeconomists use data to assess
the state of the economy, make
forecasts, analyze policy alternatives,
and test theories.

Data Development (continued)

Providers of data must:
Decide what types of data should be collected
based on who is expected to use the data and
how.
Ensure the measures of economic activity
correspond to economic concepts.
Guarantee the confidentiality of data.

Why Macroeconomists
Disagree
A positive analysis examines the
economic consequences of an
economic policy, but it does not
address its desirability.
A normative analysis tries to determine
whether a certain economic policy
should be used.

Why Macroeconomists
Disagree (continued)
Economists can disagree on normative
issues because of differences in values.
Economists disagree on positive issues
because of different schools of thought.

The Classical Approach

The invisible hand of Economics:
General welfare will be maximized (not
the distribution of wealth) if:
there are free markets;
individuals act in their own best interest .

The Classical Approach

(continued)
To maintain markets equilibrium the
quantities demanded and supplied are
equal:
Markets must function without impediments.
Wages and prices should be flexible.

The Classical Approach

(continued)
Thus, according to the classical approach,
the government should have a limited role
in the economy.

The Keynesian Approach

Keynes (1936) assumed that wages
and prices adjust slowly.
Thus, markets could be out of
equilibrium for long periods of time
and unemployment can persist.

The Keynesian Approach

(continued)
Therefore, according to the Keynesian
approach, governments can take actions
to alleviate unemployment.

The Keynesian Approach

(continued)
The government can purchase goods and
services, thus increasing the demand for
output and reducing unemployment.
Newly generated incomes would be spent
and would raise employment even further.

Evolution of the ClassicalKeynesian Debate

After stagflation high unemployment
and high inflation of the 1970s, a
modernized classical approach
reappeared.
Substantial communication and crosspollination is taking place between the
classical and the Keynesian
approaches.

Unified Approach to
Macroeconomics
Individuals, firms and the government
interact in goods, asset and labour
markets.
The macroeconomic analysis is based on
the analysis of individual behaviour.

The Unified Approach

(continued)
Keynesian and classical economists
agree that in the long run prices and
wages adjust to equilibrium levels.
The basic model will be used either
with classical or Keynesian
assumptions about flexibility of wages
and prices in the short run.