1. Essence of Macroeconomics
Macroeconomics is concerned with behavior of the economy as a whole. It
answers the questions regarding growth of output, rates of inflation and
unemployment, Balance of Payments and exchange rates and also methods
to improve the economy. It deals with both the Long-run economic growth
and the short run fluctuations that constitute the business cycle.
Macroeconomics encapsulated in three models:
The study of macroeconomics is organized around three models taking into
account different time frames.
These are:
Very Long Run behavior
Long Run behavior
Short run Behavior
The very long run behavior of the economy is the domain of growth
theory. It studies growth of economies, capacity to produce goods and
services, accumulation of capital, and improvements in technology.
In the long Run, The capital stock and technology are taken to be
relatively fixed. Fixed capital and technology determines the productive
capacity of the economy which is called potential or full employment
output. Thus the supply of goods and services equals potential output.
Prices and inflation in the long run are determined by fluctuations in
demand.
In the short run, fluctuations in demand determine how much of the
available capacity is used and thus the level of output and employment.
In contrast to the long run, in the short run prices are relatively fixed and
output is relatively variable. The short run model has a larger role for
macroeconomic policy.
Economy with fixed productive capacity:
Three substantive findings of economy:
1. Output is determined by the productive capacity which known
as aggregate supply. Aggregate demand is the total

2. demand for goods to consume for new investment, for goods
purchased by the government and for net goods to be
exported abroad. The aggregate supply curve in the long run
is vertical. The price level in contrast can take any value. It
follows that in the Long run, output is determined by
aggregate supply alone and prices are determined by both
aggregate supply and demand.
2. High inflation rates which are rapid increases in the overall
price level are always due to changes in aggregate demand.
In the short run the aggregate supply curve is flat.
3. It follows that in the short run, output is determined by
aggregate demand alone and prices are unaffected by the
level of output.
In the medium term, the aggregate supply curve has a slope
intermediate between horizontal and vertical.
The question “How steep is the aggregate supply
curve?” is in effect the main controversy in macroeconomics.
The speed with which prices adjust is a critical parameter.
Growth and GDP:
The growth rate of the economy is the rate at which GDP is
increasing. What causes GDP to grow?
There are two reasons:
1. Available amount of principal resources namely, Labour
and capital change.
2. The second is efficiency of factors of production, which
is called productivity, may change.
Business Cycle and Output Gap
Inflation, growth and unemployment are related
through the business cycle.

3. The business cycle is the deviation from the path from
trend growth. There are peaks and troughs. Peaks are
cyclical deviations where economic activity is high
relative to trend. Cyclical troughs are the low points in
the economic activity. Output gap measures a gap
between actual output and trend or full employment or
potential output. The output gap falls during recession
and conversely increases during an expansion. A
positive gap means overheating of the economy.
Inflation and Business Cycle: Increase in inflation is
positively related to the output gap. Expansionary
aggregate demand policies tend to produce inflation.
Protracted periods of low aggregate demand tend to
reduce the inflation rates. Inflation is a major
macroeconomic concern. In case of unemployment,
potential output is going to be waste. In case of
inflation there is no obvious loss of output. However
inflation reduces the efficiency of the price system.
Policy makers therefore increase unemployment
(reduced output) in an effort to reduce inflation. This is
known as growth inflation trade-off.