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MACROECONOMIC

ENVIRONMENT
1. INTRODUCTION

What Is Macroeconomics?
Macroeconomics is the study of the behavior of the economy
as a whole and the policy measures that the government uses
to influence it.
Utilizes measures including total output, rates of
unemployment and inflation, and exchange rates.
Examines the economy in the short run, long run,& very LR.
Short run: movements in the business cycle.
Long run: movement in prices.
Very long run: economic growth.
Macroeconomics aggregates the individual markets whereas
microeconomics examines the behavior of individual economic
units and the determination of prices in individual markets.

What Is 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 Is Macroeconomics?
We wonder why some countries are growing faster than
others and why inflation fluctuates. Why recessions
occur; why economies boom?
Macroeconomics deals with the performance, structure,
behaviour and decision-making of the entire economy.
Study of macroeconomics is important because the state
of the entire economy (macroeconomy) affects everyone
in many ways. It plays a significant role in the political
sphere while also affecting public policy and societal
well-being.

What Is Macroeconomics?
Macroeconomists study aggregated indicators such as
GDP, unemployment rates, and price indices to
understand how the whole economy functions.
Macroeconomists develop models that explain the
relationship between such factors as national income,
output, consumption, unemployment, inflation, savings,
investment, and international trade.
Macroeconomists are also concerned with issues such
as recessions (periods in which real GDP falls mildly)
and depressions (when GDP falls more severely), and
with monetary and fiscal policies.

Some Key Macroeconomic


Questions
Will tomorrows world be more prosperous
than today?
Will jobs be plentiful?
Will the cost of living be stable?
Will the government go into deficit again?

Origins and Issues of


Macroeconomics
Economists began to study economic growth, inflation,
and international payments during the 1750s.
Modern macroeconomics dates from the Great
Depression, a decade (1929-1939) of high unemployment
and stagnant production throughout the world economy.
The Great Depression was a period of severe economic
contraction (falling output, falling investment, falling
prices, stock market crash) and high unemployment that
began in 1929 and continued throughout the 1930s.

The Roots of Macroeconomics


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 modern macroeconomics.

The Roots of Macroeconomics


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.

Recent Macroeconomic History


Fine-tuning was the phrase used to refer to the
governments role in regulating inflation and
unemployment.
The use of Keynesian policy (of demand side
management) to fine-tune the economy till the
1960s, led to disillusionment in the 1970s and
early 1980s.
During 1970s and 1980s, economists were more
worried about slowing growth and inflation.

Recent Macroeconomic History


Stagflation occurs when the overall price level
rises rapidly (inflation) during periods of
recession or high and persistent unemployment
(stagnation).
Classical macroeconomics (of supply side
management) re-emerged to correct stagflation
in US and Europe (Barro, Sargent).

The Methodology of Macroeconomics


Connections to microeconomics:
Macroeconomic behavior is the sum of all the
microeconomic decisions made by individual
households and firms. We cannot understand
the former without some knowledge of the
factors that influence the latter.

Aggregate Supply and


Aggregate Demand
Aggregate demand is the
total demand for goods and
services in an economy.
Aggregate supply is the
total supply of goods and
services in an economy.
Aggregate supply and

demand curves are more


complex than simple
market supply and demand
curves of microeconomics.

Aggregate Supply and


Aggregate Demand
Aggregate demand (AD) equals
total spending on goods and
services. It depends on the level
of prices, on monetary & fiscal
policy & on other factors like wars
etc.
AD=C+I+G+NX.

Aggregate supply (AS)


depends upon level of prices &
costs; & productive capacity
(or potential output) of
economy, which depends on
availability of capital, labour &
technology.

Origins and Issues of Macroeconomics


While macroeconomics is a broad field of study, there
are three areas of research that are typical of the
discipline:
the attempt to understand the causes and
consequences of short run fluctuations in national
income (the business cycle), and
the causes & consequences of price fluctuations (in the
long run), and
the attempt to understand the determinants of very long
run economic growth (increases in national income).

Macroeconomics In Three Models

Study of macroeconomics is grounded in three models, each


appropriate for a particular time period.
1. Very Long Run Model: domain of growth theory - focuses on
growth of the production capacity of the economy.
2. Long Run Model: a snapshot of the very long run model, in which
capital and technology are largely fixed.
The given level of capital and technology determine the level of
potential output.
Output is fixed at potential output, but prices determined by
changes in AD.
3. Short Run Model: business cycle theories Changes in AD determine how much of the productive capacity
is used and the level of output and unemployment.
Prices are fixed in this period, but output is variable.

AS Curve In The SR, LR & VLR


VLR AS

Price
Level
AD

LR
AS

SR AS

Ypot

Output

Origins and Issues of Macroeconomics


Short-Term Versus Long-Term Versus Very Long
Term Goals
The Very Long Run behaviour of the economy focuses
on growth theory i.e it deals with the growth of the
economys capacity to produce goods & services
through accumulation of capital and improvements in
technology ( Solow, Romer ) involves a few decades.
In the Long Run, we assume productive capacity of the
economy (i.e supply of goods & services) to be fixed.
Prices and inflation, which are determined by fluctuations
in demand, are the subject of study over this time
horizon ( Classical theory ) involves a decade.

Origins and Issues of Macroeconomics


Short-Term Versus Long-Term Versus Very Long Term Goals
In the Short Run behaviour of the economy, fluctuations in
demand determine how much of the available capacity is used and
thus the level of output and unemployment. In the SR, prices are
relatively fixed and output is variable. Keynes focused on the
short-termon unemployment and lost production and business
cycles involves period of a few months to a few years.
Output and prices are determined by aggregate supply and
aggregate demand. In the SR, the AS curve is flat. In the LR, the
AS curve is vertical.
Changes in AD, which is on account of changes in fiscal and
monetary policy as well as individual decisions about consumption
and investment, change output in the SR and change prices in the
LR.

Origins and Issues of Macroeconomics


In the long run, said Keynes, were all dead.
(Mankiw, Tobin).
During the 1970s and 1980s, macroeconomists
became more concerned about the long-term and
very long term macroeconomics - inflation and
economic growth.
The 2007-2009 financial crisis has brought back
attention to Keynesian economics alongwith his
fiscal policy and monetary policy prescriptions.

Key Macro Concepts


Economic Growth and Fluctuations
Inflation
Jobs and Unemployment
Surpluses and Deficits
Macroeconomic Policy Challenges & Tools

Economic Growth and Fluctuations


Economic growth is the expansion of the economys
production possibilities.
We measure economic growth by the increase in
aggregate output. Aggregate output is the total quantity of
goods and services produced in an economy in a given
period. The main measure of how an economy is doing is
aggregate output.
Real GDPreal gross domestic productis a good
measure of aggregate output. It is the value of the total
production of all the nations farms, factories, shops, and
offices, measured in the prices of a single year (produced
over the period of one year).

Economic Growth and Fluctuations


Potential GDP is the value of real GDP when all
the economys labour, capital, land, and
entrepreneurial ability are fully employed trend
rate of growth.
Potential GDP shows productive capacity of a
nation.

Economic Growth and Fluctuations


Real GDP fluctuates around potential GDP
in a business cycle
a periodic but irregular up-and-down
movement in production.

The business cycle is the cycle of shortterm ups and downs in the economy.

Economic Growth and Fluctuations


Short Run Business Cycle
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.
An expansion is a period during which real GDP
increases.
Policy makers attempt not only to smooth fluctuations in
output during a business cycle in the SR, smoothen
fluctuations in prices in the LR, but also attempt to
increase the growth rate of output in the Very long-run.

The Business Cycle and the Output Gap


Business cycle is the pattern of expansion and contraction
in economic activity about the path of trend growth in the
SR.
Trend path of GDP is the path GDP would take if
factors of production were fully utilized-potential output.
Deviation of output from the trend is referred to as the
output gap.
Output gap = actual output potential output.
Output gap measures the magnitude of cyclical
deviations of output from the potential level.

Economic Growth and Fluctuations


Short Run Business Cycle
Every business cycle has two phases:
1. A recession
2. An expansion
And two turning points:
1. A peak
2. A trough

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.

Economic survey 2013-14

Eco survey, 2013-14 : key indicators

Economic Growth and Fluctuations


Trend Potential And Actual Output - USA

This figure shows the most recent U.S. cycles.


Peak

Recession

Potential
GDP
Peak

Real GDP

Expansion

Expansion
Trough

2010

Forecast of potential growth is between 7 and 7.5% over 2012-14.


Source : Ministry Of Finance, 2013

Potential Output, April, 2014, RBI

GDP Growth Over The Years (in %)


FY 2011 = 8.9%
FY 2012 = 6.7%
FY 2013 = 4.5%
FY 2014 = 4.7%
FY 2015 = 5.65%*
*Estimated GDP growth rate for FY15 bet. 5.4-5.9 averaged at 5.65.
source : Economic Survey, 2014-15.

Benefits and Costs of Economic Growth


The main benefit of long-term economic growth is
expanded consumption possibilities, including more
health care for the poor and elderly, more research
on cancer and AIDS, more space exploration, better
roads, more and better housing, and a cleaner
environment.
The costs of economic growth are forgone
consumption in the present, and more rapid
depletion of nonrenewable natural resources.

Introduction to Key Macro Concepts


Economic Growth and Fluctuations
Inflation
Jobs and Unemployment
Surpluses and Deficits
Macroeconomic Policy Challenges & Tools

Inflation and Deflation


Inflation is an increase in the overall price
level.
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
Inflation is a process of rising prices.
We measure the inflation rate as the percentage
change in the average level of prices or the price
level.
The Consumer Price Index CPI is a common
measure of the price level used to calculate inflation.
An alternative measure of inflation, called Wholesale
Price Index WPI, is used primarily in India.

Inflation
Is Inflation a Problem?
Unpredictable changes in the inflation rate are a
problem because they redistribute income in arbitrary
ways between employers and workers and between
borrowers (gain) and lenders (lose).

Eradicating is costly because it brings a period of


greater than average unemployment.

Inflation Rates, India

Inflation Rates, India

source : RBI, M&MD, April, 2014

Introduction to Key Macro Concepts


Economic Growth and Fluctuations
Inflation
Jobs and Unemployment
Surpluses and Deficits
Macroeconomic Policy Challenges & Tools

Unemployment
The unemployment rate is the percentage of
the labor force that is unemployed and looking
for a job.
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?

Jobs and Unemployment


Why Is Unemployment a Problem?
Unemployment is a serious economic, social, and
personal problem for two main reasons:
Lost production and incomes
Lost human capital
The loss of a job brings an immediate loss of income and
productiona temporary problem.
A prolonged spell of unemployment can bring permanent
damage through the loss of human capital.

Unemployment Data, India

Source: RBI First Qtr Review, 2011-12

CDS unemployment rate was 5.6% in 2011-12 (68 th round of


NSSO).

Introduction to Key Macro Concepts


Economic Growth and Fluctuations
Jobs and Unemployment
Inflation
Surpluses and Deficits
Macroeconomic Policy Challenges & Tools

Surpluses and Deficits


Domestic/Government Budget Surplus and
Deficit
If a government collects more in taxes than it
spends, it has a government budget surplus.
If a government spends more than it collects in
taxes, it has a government budget deficit.

Surpluses and Deficits


International Surplus and Deficit
If a nation imports more than it exports, it has an international
(trade) deficit.
If a nation exports more than it imports, it has an international
(trade) surplus.
The current account deficit or surplus is the balance of
exports minus imports plus net interest paid to and received
from the rest of the world.
Deficits are a problem since it is a liability for governments
and makes them dependent on lenders, domestic or
international.

source : Economic survey, 2013-14

Introduction to Key Macro Concepts


Economic Growth and Fluctuations
Jobs and Unemployment
Inflation
Surpluses and Deficits
Macroeconomic Policy Challenges & Tools

Macroeconomic Policy Challenges


Five widely agreed policy challenges for
macroeconomics are to:
1.
2.
3.
4.
5.

Boost economic growth


Keep inflation low
Stabilize the business cycle
Reduce unemployment
Reduce government deficits

Macroeconomic Policy Tools


Government in the Macroeconomy
There are three kinds of policy that the
government has used to influence the
macroeconomy:
Fiscal policy
Monetary policy
Growth or supply-side policies

Macroeconomic Policy Tools


Government in the Macroeconomy
Fiscal policy refers to government policies concerning
taxes and spending.
Monetary policy consists of tools used by the Central
Bank to control the quantity of money in the economy.
FP & MP affect AD of economy.
Growth policies are government policies that focus on
stimulating aggregate supply instead of aggregate
demand. Such policies affect AS of economy.

Why Macroeconomics?
Macroeconomic models and their
forecasts are used by both governments
and large corporations to assist in the
development and evaluation of economic
policy and business strategy.

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