CHAPTER-ONE

THE STATE OF MACROECONOMICS

1. Introduction
1.1 what is macroeconomics is about?
Economics is a science which studies human behavior as a relationship between unlimited ends
and scarce resources with alternative uses. It studies human action regarding how s/he satisfies
his wants (all goods and services) with scarce resources. In short, it deals with how scarce
resources are allocated among the competing needs. Traditionally, economics is divided into
two: microeconomics and macroeconomics.
 Microeconomics studies the behavior of individuals and organizations (consumers,
firms and the like) at a disaggregated level while macroeconomics studies the overall or
aggregate behavior of the economy.
o That means macroeconomics explains phenomena such as inflation,
unemployment, and economy growth while microeconomics concerned with
the demand for or supply of a specific commodity.

Definition
Macroeconomics is a branch of economics that deals with aggregate components of the
economy. In other words, macroeconomics is concerned with the behavior of the economy as a
whole-
 with booms and recessions,
 the economy's total output of goods and services and the growth of output,
 the rate of inflation and unemployment,
 the balance of payments, and
 exchange rates
Macroeconomics focuses on the economic behavior and policies that affect consumption and
investment, trade balance, the determinants of changes in wages and prices, monetary and
fiscal policies, the money stock, government budget, interest rate, and national debt. Besides,
macroeconomics concerned with both explanation and policy prescriptions. Explanation
involves an attempt to understand the behavior of economic variables, both at a moment in
time and as time passes.
Economists play two roles:
o Scientists –try to explain the world
o Policy advisor –try to improve the world
As scientists, economists make positive statements, which attempts to describe the
world as it is.
o For example, price rise when the government increase the quantity of

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 money in the economy.
As policy advisors, economists make normative statements, which attempts to
prescribe how the world should be.
o For example, the government should print less money.
Positive statements can be confirmed or refuted, normative statements cannot.
The Government employs many economists for policy advice.
o For example, economists at Finance to help design tax policy; economists
at HRDC help formulate labor-market policies; economists at
Environment to help design environmental regulations.

The macroeconomics policy of any country focuses in achieving the following three most
important objectives. These are:
1. Economic growth. This refers to the growth of output (GDP) in an economy.
2. Stability of the economy. This refers to achieving low or stable inflation (Л), nominal
interest rate (r), and exchange rate.
3. Reducing unemployment, particularly the cyclical unemployment which is the outcome of
poverty. Poverty is the outcome of many factors. Some of the factors include socio-economic
backwardness, natural hazards, war, poor governance (administration) of a nation and poor
policies. Frictional and structural unemployment, which are caused due to poor or imperfect
information and change in technology respectively, can be addressed easily. Therefore, their
effect on an economy is temporary. As a result, economic policy makers give due attention or
emphasize to address the cyclical unemployment which could be permanent unless they are
capable using different macroeconomics instruments.
1.2 Basic Concepts and Methods of Macroeconomic Analysis
Measuring the Value of Economic Activity: Gross Domestic Product
The single most important measure of overall economic performance is Gross Domestic
Product (GDP). The GDP is an attempt to summarize all economic activities over a
period of time in terms of a single number, i.e. it is a measure of the economy's total
output and total income. In other words GDP is the value of all final goods and
services produced in the economy in a given time period by using the resources supplied by
either the citizens or foreigners.
Macroeconomic methodology is an inquiry into the question of how to conduct a proper
scientific analysis of uncertainty within macroeconomics. It will be of great interest to

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 scholars of the philosophy of social sciences and methodology, as well as post-Keynesian
and heterodox economists.
Basic macroeconomics focuses on five main principles. These are economic output,
economic growth, unemployment, inflation and deflation, and investment.

1.3Macroeconomics instruments
The most important instruments among others include monetary policy, fiscal policy, income
policy, and labor policy. Macroeconomics thinking has stages of evolutions. Throughout its
stages of development there has been consensus that the above three are the main objectives of
macroeconomics. However, schools of thoughts disagree on the policy instruments they
prescribe to achieve them. This disagreement is discussed in detail in the section that follows.
1.4 Evolution of macroeconomics schools of thoughts and recent development
Available documents suggest that formal study on economic issues was started around 2 century
AD in ancient Greek philosophy/wisdom. This implies that economics is an old science like Art,
literature, Astronomy, Mathematics, Physics, Medicine, and the like. Plato and Aristotle were the
two prominent (famous) ancient Greek philosophers who produced enormous economic articles
on economics that served as foundation/basis for further studies and advancement of economics.
However, the studies of scholars conducted on economic issues and theories developed up to the
industrial revolution of the 18th century focus only on microeconomic issues. Macroeconomics as
a branch of economics was emerged 238 years back with the writing of Adam Smith “The wealth
of Nation” in 1776. The historical evolution of macroeconomics from 1776 to date is discussed
briefly by dividing it into two broad categories: the orthodox and recent/contemporary
macroeconomics schools.
The orthodox macroeconomics: includes macroeconomics thinking of schools of thoughts
evolved between 1776 and 1975. The three schools of thought categorized under the
orthodox macroeconomics school are the classical school of thought, the neo-classical
school of thought, and the Keynesian macroeconomics.
1.4.1 The classical school of thought (1776 - 1870)
This is the era of the marginalist approach (thought). During this period, the distinction between
micro and macro economics was not clear. The ruling principle (the dominant idea) of this
school of thought was the invisible hand or laissez-faire (which means leave the market free or

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free market) coined by Alfred Marshall and advocated by Adam Smith. The reason for their
argument was that supply will create its own demand or price set by the private sector alone will
automatically correct/equilibrate any imbalance or disequilibria created in the economy both in
the short run and the long run without government intervention. This law is called the “ Says
law”.
Adam Smith also described the government as the necessary evil and hence advocated that the
government should refrain from intervening in the market. For Adam Smith and his followers
any government policy is ineffective to correct economic disorder or disequilibrium. In other
words, government intervention will distort the market rather than stabilizing.

1.4.2 The Neo classical school of thought (1870 - 1936)

The idea of the neoclassical school of thought was not different from the classical school. The
only difference between the two schools of thought is the contribution that is made by Adam
Smith and David Ricardo respectively on ‘absolute and comparative advantage’ of nations in
international trade.

Adam Smith (1723-1790) provides the basic building blocks of the construction of the classical
theory of international trade. He enunciated the theory in terms of what is called Absolute
Advantage model. Another well known classicist, David Ricardo (1772-1823) articulated it and
expanded further in to what is called comparative advantage model.

The models of Smith and Ricardo together constitute what is sometimes referred to as the supply
version of the classical theory of trade, because Smith and Ricardo paid almost exclusive
attention of considerations of supply or production costs in the determination of terms of trade
and the gain from trade. The modern version however treats supply and demand with equal
weight.
Note that:
The concept of Absolute Advantage is concerned with differences between actual
efficiency of production. Or it shows the ability of a given nation to produce a
good at lower costs whereas; the concept of Comparative Advantage is about the

relative efficiency of production. Or it shows the ability of a given nation to

produce a good at lower opportunity costs.

1.4.3 The Keynesian macroeconomics (1936-1975)

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An American economist called Keynes challenged/criticized the classical wisdoms of
macroeconomics based on the events or episodes during the great economic depression of the
early 1930s (1929 to 1935). The great depression was caused by excessive or overproduction of
wheat and coffee. Due to excess production than demanded the price of wheat and coffee goes
down, implying supply fails to create its demand as argued by the classical. So, the main thesis
of the Keynesian stream is that the economy is subjected to failure so that it may not
achieve full employment level. Thus, government intervention is inevitable (unavoidable).

Recent Developments in Macroeconomics (1970s – Present)

There is no dominant school of thought of macroeconomics from 1970s onward. There have
been two main intellectual traditions in macroeconomics. One school of thought believes that
government intervention can significantly improve the operation of the economy; the
other believes that markets work best if left to themselves.
 In the 1960s, the debate on these questions involved Keynesians including Franco
Modigliani and James Tobin on one side and monetarists led by Milton Friedman
on the other.
 In the 1970s, the debate on the same issues brought to the new group- the new classical
macroeconomists, who by and large replaced the monetarists in keeping up the argument
against using active government policies to try to improve economic performance.
 On the other side are the new Keynesians; they may not share many of the detailed belief
of Keynesians except the belief that government policy can help the economy to perform
better.

Concluding Remark

All school of macroeconomics agree on the purpose of macro policy but they disagree on how to
achieve the macro objectives of higher output, lower level of unemployment and inflation
rate.

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