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Nature and scope of macroeconomics

1. Studies large aggregates like employment, national product, general price level, productive
capacity, growth, inflation, balance of payments etc. in short and long term
2. Originated after great depression when capitalist economies experienced large scale
unemployment, sharp fall in GDP, decline in private investment, lack of aggregate demand.
3. US had about 25 percent unemployment in 1933. Keynes lay foundations for modern
macroeconomics by pointing out that classical economists were faulty in applying microeconomic
models to explain depression and involuntary unemployment. He emphasized that lack of private
investment has resulted in lack of aggregate effective demand. He also said that market
economy is not self-correcting and government intervention is needed to restore full
employment in the economy.
4. Classical and neo-classical economists assumed full employment of labor and other resources
and concentrated on determination of prices, output and resource employment. According to
them market economy is self-adjusting and even if deficiency in aggregate demand arises as a
result of depression, prices and wages will change in a manner such that output, employment
and national income will not decline. They believed in says law which stated that supply creates
its own demand and therefore problem of lack of demand for supply of goods doesnt arise. This
is so because factors gets reward for producing in forms of wage, interest and rents which in
turn become expenditures on goods and services. Classical economist Pigou tried to apply
models suitable for one industry to overall economy. They believed trade unions and
government become obstacles and hamper functioning of free market thus creating depression.
5. However it soon became clear that depression situation was not self-correcting and classical
economists were proved wrong. Keynes challenged there viewpoint and said that if wages are
cut, it will reduce incomes and further hamper aggregate demand and result in lower level of
employment rather than expanding it. In his general theory of employment, interest and money
he attacked says law, full employment assumption and suggested that due to imbalance
between aggregate demand and aggregate supply the full equilibrium might be established
below full employment as labor and productive capacity remain unutilized. His macroeconomic
model revealed how consumption function, investment function and liquidity preference function
in aggregate terms interact to determine income and employment.
6. Modern macroeconomics later included issues such as inflation, economic growth, business
cycles, stagflation, balance of payments and exchange rate in its scope.
Major issues and concerns of macroeconomics
1. Determination of Employment and unemployment
2. Determination of National income, deviation from potential GNP, in developed and developing
3. General Price level and inflation Here Keynes attacked classical quantity theory of money
which attributed inflation largely to increase in money supplied. Keynes argued that inflation is
result of increase in aggregate demand and put forth theory of demand pull inflation. He
explained it in hoe to pay for war published post World War 2. Post Keynes many theories like
cost push inflation and structural inflation are put forth by economists
4. Business cycles- fluctuations in output and employment in booms and recession, severe
recession ( depression) and monetary and fiscal keys to achieve macroeconomic stability at full
5. Stagflation Recession along with inflation coexist ( since 1970s) which is explained by supply
side economics
6. Economic Growth- sustained increase in GNP or PCI over a long period. Depends on Natural
resources, physical capital, human capital, population and technology. These factors can be
increased by increasing saving and investments. However, to use this increased capacity
aggregate demand should also be elastic enough so that there exists opportunity to supply more
for increased demand. Keynes didnt consider long run (In the long run we all are dead). Harrod
and domar extended Keynesian analysis for long run stressing dual role of investment (capacity
creating-supply and income generating-demand). They believed that for sustained growth
income should also be growing. Later, Solow, Meade, kaldor, Robinson came with growth
It is important that growth and development have different meaning in developing countries.
Development is more inclusive concept of growth and means reduction of poverty, inequality
and unemployment apart from economic growth. According to amartya Sen. It is building of
capabilities of poor and enlargement of opportunities to gain freedom in these respects. Special
growth theories which deal with causes of problems and strategies to accelerating growth in
least developed economies are called Economics of development. They are given by Nurske-
balanced growth theory, Hirschman- unbalanced growth theory, and Lewis- unlimited supply of
labor (labor surplus theory.
7. Balance of payments and exchange rate Balance of payment is record of all economic
transactions of residents of a country with rest of the world during a period. Goods and services
exchanged, capital exchanged are reflected in it. Both deficit and surplus pose problems. They
are influenced by exchange rate. Instability of exchange rate has often caused Bop crisis. India
1991 to 2001, SEA economies, Japan 1997-98 faced severe problems on account of depreciation
of currency.
Role of government in the macro economy
1. Fiscal policy- Taxation and expenditure decisions of Government. Before Keynes balanced
budget was preferred. He advocated deficit budget in case of depression to eliminate involuntary
unemployment. Deficit budget means expansionary fiscal policy which raises income and
employment by raising aggregate demand. To finance deficit Government borrows from banks
and public and pays interest to them which raises the debt burden. Borrowing by government
also means increase in demand for loanable funds hence interest rate increases. This result in
crowding out of private investment so that net effect of deficit on expansion is small. To avoid
borrowing alternate way of financing I by printing money however it carries danger of inflation.
On the contrary when there is inflation government can reduce expenditure and increase taxes
to reduce AD and hence curb inflation. Hence, Fiscal policy is an important instrument by which
Government influences AD and thus income, employment and price level.
2. Monetary Policy- Used by central bank to ensure price stability, full-employment and economic
growth. It refers to policies regarding Growth of money supply, credit availability and cost of
credit. It includes tools like interest rate increase, reducing availability of credit (CRR), Open
market sale of Govt securities to control money supply and hence reduce inflation. Decrease in
credit reduces aggregate demand and puts downward pressure on prices. On the contrary, to
get economy out of recession expansionary policy is followed. However, efficacy of monetary
policy in depression (unemployment plus low output) is not much as per Keynes. This is because
demand for money at depression is highly interest elastic and hence increase in money supply
will not reduce interest rate significantly. Further, He stated that investment is not much interest
elastic and hence increase in interest rate will not increase investment.
3. Growth Policies- Supply side economics argues that govt should shift from influencing demand
side to influencing supply side. They believe fiscal and monetary theories are not enough for
growth. For example taxes can be reduced so that there is more investment and more supply so
that prices fall and at the same time output will increase. In developing countries It is believed
that higher economic growth reduces poverty and unemployment- Moderate taxes generate
more revenue than high taxes because of greater compliance- Govt should invest in
infrastructure and social sector. Developing economy cannot rely only in the private investment
with profit motive and public investment should supplement it.
Post Keynesian developments in Macroeconomics
1. Monetarism- Milton Friedman and Anna Schwarz in A monetary history of the United States
argued that monetary policies play key role in causing fluctuations in economic activities by
influencing aggregate demand, thus criticizing Keynes pessimism about efficacy of monetary
policy in addressing recession and bringing economic stability. He argued that depression was
actually caused by overly tight monetary policy followed by central bank and not due to failure
of market economy. Hence he differed on Role of Govt in economy and relationship between
money supply and inflation. He suggested that inflation is always and everywhere a monetary
phenomenon by making improvements while retaining core of classical economics that increase
in money supply relative to output causes inflation. They believe that Govt should not follow
active discretionary monetary policy but rather focus on stable growth of money supply. They
also discredited role of deficit budgets and suggested that both tax and expenditure should be
kept minimum so as to restrict govt role.
2. Supply Side Economics- since 1970s stagflation (recession alongside inflation) occurred on scene
which proved that Keynesian approach of AD being responsible for either high unemployment or
high inflation cannot explain stagflation. Both problems could not be addressed simultaneously
by Keynesian approach of influencing aggregate demand. They advocated approach of
increasing incentive to work, save and invest by reducing taxes which will increase aggregate
supply in economy and also put downward pressure on prices. It will not reduce the tax revenue
as suggested by Laffer curve, because output will increase to such an extent that reduction due
to tax rate decrease will be made up for.
3. New Classical macroeconomics based on rational expectation- It suggested that govt policies will
not be able to handle macroeconomic problems because all stakeholders evaluate the policy
decisions and make adjusting endeavors. For example if money supply is increased all will
expect price rise and hence labor will get wages increased, landlords will increase rents,
businessmen will increase profit margins. As a result effect on output and employment will get
nullified and evened out. This approach assumes that stakeholders will not make wrong
evaluations and make adjustments quickly enough to suit their self-interests. So involuntary
unemployment will not prevail. Main difference with Keynesian approach is that, instead of
increasing aggregate demand and hence promoting private investment, budget deficit will cause
higher interest rate and hence discourage private investment. Hence govt activism cannot
attend any success according to this approach. Individuals are in better position to take
corrective measures to safeguard their own interests.
Why a separate study of macroeconomics
1. What is true of parts is not true for the whole, Hence applying micro concepts will be erroneous
2. Thrift paradox- At depression more savings result in deepening the crisis. This is because
consumption demand falls and reduces aggregate demand further. With more saving income
and employment will reduce and then at reduced income savings will fall to original level but
consumption will be lower than previous level hence people will be worse of. Income
determination and multiplier theory suggest that income and employment fall will be more than
original savings rise. Thus while saving is good for individuals in general it may not be good at
aggregate level.
3. Wage Employment paradox- If wages are cut in an industry then labor employed in the industry
will rise. But if this is applied to whole economy then as aggregate demand also falls, demand
for consumption will decrease and hence there will be unemployment as there is no incentive to
produce more and less labor will be employed.
4. Fallacy of composition- saving and investment may differ for individuals but for whole economy
they are equalExpenditure may be more or less than income for individuals but for while
expenditure equals income An industry may attract employees of other and thus increase
output but as a whole output cannot be increased this way.
5. Due to all these fallacies and paradoxes which arise when we do microeconomic and
macroeconomic analysis there is need for separate study of macroeconomics
Importance of macroeconomics
1. To understand working of macro economy Macroeconomic paradoxes + National Income +
Employment + Price level + fallacies its not same as aggregate of parts
2. Important nature of macroeconomic issues important for wellbeing, poverty , inequality,
inflation, unemployment
3. Importance for accelerating economic growth- Technology, Investment level, saving, AD, causes
of slowdown
4. Understanding business cycles- fluctuation in aggregate demand due to volatile nature of
investment demand, together with interaction of multiplier and accelerator explain business
cycles to considerable if not full extent
5. Formulating Govt macroeconomic policies- Monetary, fiscal and growth inflation, recession,
growth, exchange
6. Individual decision making- Loan, Buying now or later, Effects of inflation
7. Business decisions- Investment climate, real return, demand conditions, investment decisions