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Macro I Chapter one.pptx

  2. 1.1 What macroeconomics is about? • Economics is divided in to two major branches: Microeconomics and Macroeconomics. • Microeconomics – Deals with economic behavior of an individual decision-making unit (consumer and producer) or an economic variable (Price and quantity of a good)
  3. Cont.… Macroeconomics • Macroeconomics, branch of economics concerned with the aggregate, or overall, economy. • Macroeconomics deals with economic factors such as total national output and income, unemployment, balance of payments, and the rate of inflation. • Is the study of the behaviour of the economy as a whole. It concerns the business cycles that lead to unemployment and inflation, as well as the longer-term trends in output and living standards.
  4. Cont.. • The state of macroeconomics affects everyone’s life; they play a central role in political debate. • Countries fix their relation with the others based on their macroeconomic policies. • It is also the base for the regional economic integration. example, Europe has moved towards a common currency, COMESA set a tax exemption region among the member countries etc.
  5. Cont.… Macroeconomics is a young and imperfect science  Macroeconomists were not generally successful in predicting the global economic crisis of 2008  Even after the crisis, they were unable to agree on what should be done to deal with the crisis Nevertheless, the importance of the subject is clearer than ever
  6. 1.2 Method of macroeconomics analysis • Macroeconomics is the study of the economy as a whole • Macroeconomists collect data on incomes, price levels, interest rates, unemployment, and many other macroeconomic variables from different time periods and different countries • They then try to build general theories to explain the data that history gives them
  7. Cont.. • Economic Model: is a theory that summarises, often in mathematical terms, relationships among economic variables. • Theory: is a system of ideas explaining something, especially one based on general principles independent of the particular things to be explained. Or, • An economic theory is a generalisation based on a few principles that enables us to understand and predict the economic choices made by people.
  8. Cont.. • Exogenous Variables: are determined outside of the model. • Endogenous Variables: are determined within the model. And do capture the decisions made by people in which we are primarily interested in learning about. • In building economic models economists tend to assume two general principles about how people and the societies in which they exist behave in trying to understand the decisions made by people:
  9. Cont.. • Optimisation Principle-people are motivated by self-interest, or equivalently, that people try and do the best they can. • Equilibrium Principle-that people’s actions tend to become consistent with each other. In the limit the economic forces are so balanced that there is no tendency for people’s behaviour to change.
  10. 1.3 Macro goals Continues… –Full employment –High living standards –Price stability –Reduction of economic inequality –Rapid economic growth –Steady foreign exchange position
  11. Policy Instruments • Fiscal Policy • Monetary Policy • Other, employment, international trade, price & income policy
  12. Cont. • Fiscal Policy –concerned with the use of taxes and government expenditures. –Government has to meet various expenditures like salaries, defense expenses, infrastructure development, etc – All these expenses leave a positive effect on the overall economy
  13. Cont… – The other part of the fiscal policy is generation of revenues for the government. – Taxes are the main source of revenue for any government. – Taxes affect the economy and the individuals in two ways. • bring down the disposable income in the hands of the consumers. This reduces the spending in the economy. • Second, the taxes levied on goods and services make them costlier. This discourages the firm to invest in capital goods.
  14. Monetary Policy – is the second most widely used macroeconomic policy instrument. – helps government, managing the nation’s money, credit, and banking system. – There are various entities that are part of the monetary system of an economy. – Central bank regulates the monetary system, and other entities like banks, insurance companies are also a part of the monetary system. – In Ethiopia, National Bank of Ethiopia is the custodian of the monetary system of the economy.
  15. Cont. • Central bank brings changes in the interest rates, reserve requirements, etc. These changes make significant impact on the overall functioning of the economy. • For example, the lowering of interest rates on housing loans helped the growth of the housing sector. As a result of low rate of interest, it became easier to avail a housing loan and to own a house. Employment Policy – adopted by government in order to increase the employment level in the country. Price and Incomes Policy – This policy aims at regulating the prices in the market and also to ensure the minimum wages to the workers.
  16. Cont.… • International Trade Policy – Globalization has given a big push to the international trade. This has resulted in framing of specific polices by many countries to cope with the new challenges. International trade policy addresses issues like tariff and non tariff barriers.
  17. 1.4 Evolution of macroeconomics • Economic thinking has begun since the cradle of mankind • Since today’s knowledge of the economics evolves over time based on preexisting knowledge and some historical events. To do so, we have to look different schools of thought of macroeconomics.  Classical 1776-1936  Keynesian 1936- 1970  After 1970 there is no dominant school of thought in macroeconomics .there are different schools of thought with different ideas (Monetarism, new classical, new Keynesians, institutional and others).
  18. 1.4.1 Classical school of thought • It is a macroeconomics idea of 1776-1936 periods. During this time, there was no unified or formalized theory of aggregate employment and origin of business cycle. • Classical economists : Adam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and others— wrote from the 1770s to the 1930s • The ruling principle was the invisible hand coined by Alfred Marshall. Major Assumption • All markets including labor market always clear (the economy always operates at equilibrium and at equilibrium all resources are fully employed). • No government intervention is needed in the form of stabilization policies, it is neither desirable nor necessary to achieve full employment.
  19. Cont.… • Economic agents (firms and households) are rational and aim to maximize their profit or utility. • All markets are perfectly competitive so that agents decide how much to buy and sell on the basis of a given set of prices which are perfectly flexible. • All agents have perfect knowledge of market conditions and prices before engaging in trade. • Trade only takes places when market –clearing prices have been established in all markets. • Agents have stable expectation.
  20. Cont.. • Classical macroeconomists explain the determination of crucial macro variables by dividing the economy in to two sectors: the real sector and monetary sector. This is usually known as classical dichotomy. They should be studied separately. • Demand-side policies mainly affect nominal variables such as interest rate and prices while supply side polices affect real variables such as real wage, employment and output.
  21. Cont.. • Classical used short run production function to explain the determinants of real output. At micro level production function shows the relationship between the maximum outputs levels produced from a given amount of inputs. • The more input, labor and capital that a firm uses, the greater will be the output produced. When we consider the economy as whole the quantity of total output (GDP) will also depends on the amount of input used and how efficiently they are used. • Where; Y - real output, L-amount labor used, K-capital used, and • Y= f A(K,L)
  22. Cont..... Classical & Neo-classical Macroeconomics Basic Assumptions: Flexible wages and prices. Supply creates its own demand, Say’s Law. Forward-looking agents with perfect foresight. The price level is proportional to the money stock in the long run. Main argument: No need for government intervention as the economy has a self-correction mechanism. Inflation is caused by excessive growth in money stock.  No distinction b/n macro- & micro-economics.
  23. Cont.. 1.4.2 Keynesian Macroeconomics  The birth of modern macroeconomics is linked to the Great Depression (period of high unemp’t & stagnant production) & Keynes.  The market adjustment concept of classicals & neoclassicals didn’t work during 1929-1933.  Basic Assumptions:  Economy is unstable due to shifts in AD.  Nominal wages & prices are inflexible, esp. downwards.  Large multiplier effect for changes in government spending & tax rates.  Keynes emphasized “effective demand” or AD, and proposed expansionary policies.
  24. Cont... These Policies are fiscal & monetary: 1. Increasing government expenditure (G): G  AD  Y (production). Y (output/income)  C (Consumption)  AD  Y ... – the multiplier effect. 2. Increasing money supply (M): M  r (interest rate)  I (investment)  AD  Y ... – the multiplier effect. But, all the M may be absorbed at the existing r (esp. when recession is deep) – the economy is in liquidity trap! With liquidity trap, the Classical model is incapable of producing equilibrium – Keynes.  Keynes preferred fiscal to monetary policy.
  25. 1.5 The State of Macroeconomics: Evolution & Recent Developments 1.5.1 New Classicals  In the 1970s, the debate on active policy brought to the fore new groups – new classicals & new Keynesians.  New classicals attached great importance to the role of expectation in influencing macro-economic equilibrium.  They introduced macroeconomic analysis from micro foundations.  Expansionary fiscal policy tends to increase inflationary expectations, shifting AS, causing real GDP to fall & the price level to rise.  Many of them supported supply-side policies meant to raise growth rate of potential GDP.
  26. Cont. 1.5.2 New Keynesians  They gave micro foundation for Keynesian thoughts.  Markets sometimes do not clear even when individuals are rationally looking out for their own interests.  Emphasize imperfections in various markets (labor, credit, product).  Information problems & costs of changing prices may lead to price rigidities, causing macroeconomic fluctuations in output & emp’t.
  27. Cont....  Their central working assumptions are:  forward looking economic agents with rational expectations.  Markets clear.  AS is responsive to changes in expectations about inflation.  Incentives to produce, work & save are affected by government policies which influence marginal tax rates and subsidize households and businesses.  The self-correction mechanism is based on shifts in AS caused by changes in expectations of inflation.
  28. 1.2 The State of Macroeconomics: Evolution & Recent Developments 1. New Keynesians  They gave micro foundation for Keynesian thoughts.  Markets sometimes do not clear even when individuals are rationally looking out for their own interests.  Emphasize imperfections in various markets (labor, credit, product).  Information problems & costs of changing prices may lead to price rigidities, causing macroeconomic fluctuations in output & emp’t.