3. Branches of Economics
• Microeconomics examines the behavior of
individual decision-making units—business
firms and households.
4. • 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.
5. What is macroeconomics?
• First look at :
• Output and its rate of growth
• Inflation rate
• Unemployment rate
• International trade
6. Measuring Economic growth
• Gross Domestic Product (GDP)
Value of all the final goods and services produced
within a country in given period of time.
• Real GDP
The volume of goods and services produced within a
country (i.e. GDP adjusted for inflation)
• Economic growth
Percentage rate of increase of real GDP
7. Measuring Inflation
• Inflation is an increase in the overall price level.
• Percentage change in the price level
• GDP Deflator
• Consumer price index (CPI)
8. Measuring Unemployment
• Labor force = employed + unemployed
• Unemployment rate = unemployment/labor force
• Unemployment= Does not have a job and has been
seeking for a job for past 4 weeks.
• The long term unemployment is the share of
unemployed persons since
12 months and more in the
total numbers of the active
persons in labor market.
9. International trade/ Trade balance
• The balance between imports and exports.
• Balance of trade = exports are equal to
imports.
10. Three Models
• Macroeconomics is organised around three
models
• Each model is concerned with different time
frames
– The long run
– The medium run
– The short run
• Let’s consider each in more detail
11. Very Long Run Economic Growth
• Growth theory describes the long run
behaviour of the economy
• The time is usually measured in multiples of
decades (e.g. 20 years or more)
• The focus is on the average growth in
important macroeconomic variables
• Short-run fluctuations in important variables
like employment, investment and output are
ignored
12. Very Long Run Economic Growth
• The long run level of output is determined
solely by supply-side considerations
• That is, output is determined by the
productive capacity of the economy
• All factors of production are assumed to be
fully employed
• Economic growth is, therefore, a function of
increases in productive capacity
13. Very Long Run Economic Growth
• Differences in average growth rates of
economies are important
• Major causes of economic growth are
– Development of new technology
– Accumulation of physical and human capital
– Appropriate provision of infrastructure
– Higher rates of domestic saving
14. Very Long Run Economic Growth
• Economic growth determines the changes in the
standard of living
• A country growing at an average of 4% per year
instead of 2% will have a 50% higher standard of
living over a generation of 20 years
• This higher 4% average annual growth rate will
lead to a seven fold increase in the standard of
living over 100 years!
• Let’s now introduce a model which will be useful
for our analysis
15. Fixed Productive Capacity
• What determines the change in the overall
price level (the inflation rate)?
• The aggregate supply (AS)–aggregate
demand (AD) model explains short- to
medium-run determination of inflation and
real output
• In the long run the productive capacity of the
economy is assumed to be constant
16. Fixed Productive Capacity
• This is represented by a vertical AS schedule
at real output level Y0
P AS
Price Level
Y0 Y
17. Fixed Productive Capacity
• The AD schedule represents, for each price
level, the level of output where both the
goods and money markets are in equilibrium
• These schedules will be fully explained in
next lectures
• The intersection of the AS and AD schedules
determines the price (P0) and real output (Y0)
18. Fixed Productive Capacity
• AD and AS in the long run
What happens when AD
P AS shifts rightwards?
AD
Price increases
Price Level
P0 What happens when AS shifts
rightwards?
Price decreases
Y0 Y
19. The Short Run
• Short-run fluctuations in real output are
important
• AD is the major determinant of these
variations
• In the short run the price level is pegged at
P0 making the short-run AS schedule
horizontal
20. The Short Run
• AD and AS in the short run
What happens when AD
P shifts rightwards?
Price unchanged
Price Level
P0 AS
AD
Y0 Y
21. The Medium Run
• How do we describe the transition between
the short run and long run?
• High AD pushes real output above Y0
(according to the long-run model)
• Over time, firms will increase prices and the
AS curve will move upwards
• The medium run will give an upsloping AS
curve
22. The Medium Run
• The relative steepness of the AS curve is a
major controversy in macroeconomics
P
Price Level
P0
AS AD
Y0 Y
23. To Reiterate …
• Growth theory, AS and AD form a very
important framework for the further
analysis of
– Growth and GDP
– The business cycle
• Let’s consider each in turn
25. The Business Cycle and GDP
• The business cycle describes the variation of
economic activity around the path of trend
growth
• Inflation, growth and unemployment all
demonstrate cyclical patterns
• The output gap measures the difference
between actual and potential output:
Output gap = potential output – actual output
26. • Potential Output:
Total gross domestic product (GDP) that could be
produced by an economy if all its resources were
fully employed.
• Actual Output
Actual output is the "real" GDP ( gross domestic
product).
27. The Business Cycle and Inflation
• Increases in inflation are inversely related to
the output gap
• Expansionary AD policies tend to produce
inflation when unemployment is relatively
low
• The cost of the cycle above trend is inflation
and the cost below trend is unemployment
28. Business Cycle Features
• Business cycles have common characteristics
• Procyclical variables rise with expansionary
business activity (e.g.
output, employment, interest rates and
money supply)
• Countercyclical variables (like inventories and
bankruptcies) move in the opposite direction
to business activity
29. • Procyclical has a different meaning in the
context of economic policy. In this context, it
refers to any aspect of economic policy that
could magnify economic or financial
fluctuations.
• An economic policy that is believed to
decrease fluctuations is called countercyclical.
30. Business Cycle Features
• Some variables exhibit more variability than
others (e.g. inventories are volatile while
consumption is smooth, especially relative to
output)
• The impulse-propagation model describes:
– how a shock (impulse) disturbs the economy
from a long-run trend
– which lasts (propagates) over time
• Economists disagree over possible
propagation mechanisms
31. Business Cycle Features
• There are three broad types of shocks
– Policy shocks which affect fiscal expenditure
and interest rates (e.g. fiscal and monetary
policies)
– Supply shocks which affect production and
price-setting (e.g. technology advances)
– Private sector shocks which affect aggregate
demand (e.g. changes in private investment)
32. Business Cycle Features
• There is debate about the actual timing of
business cycles
• Which measure should be used?
– Variables like unemployment lag changes in
real GDP (called lagging indicators)
– Leading indicators like firms’ profitability and
building approvals precede changes in GDP
– Aggregating variables into a composite index
will give a coincident index to measure turning
points in the business cycle
33. Business Cycle Features
• Another debate concerns separating the
cycle from trend
– The classical business cycle considers actual
levels so that a fall in GDP describes negative
growth
– Two consecutive quarters of negative growth
in real GDP is called a (classical) recession
– The growth cycle considers fluctuations in
growth rates of the economy around the trend
growth rate
34. 1.3 Schools of Thought
• During the 1960s there were two main
views
– The monetarists believed the economy is best
left to itself
– The Keynesian’s argued that government
intervention could improve economic
performance
• Two schools have developed since then
– the new classical school in the 1970s
– the Keynesian school in the 1980–90s
35. New Classical School
• Consistent with the monetarist view
– Economic agents optimise
– Decisions rationally use all available
information (rational expectations)
– Markets are assumed to clear
• These assumptions ensure there is no
involuntary unemployment
• The real business cycle extension argues that
real supply side shocks are the major causes
of fluctuations in economic activity
36. New Keynesian School
• Extends the earlier Keynesian view that
markets will not always clear even if agents
are maximising
• Reasons are varied and include
– There is incomplete information
– Institutions affect the workings of markets
– Costs of changing wages and prices lead to
price rigidities
• These reasons explain fluctuations in output
and employment
37. Economic Controversies
• The two main competing views of modern
macroeconomics are highlighted in real-
world political and media discussions
• Frequently these differences are exaggerated
in debate
• There are significant areas of agreement
• Debate and research continually evolve new
areas of consensus e.g. there is increasing
agreement on information problems with
wage-price setting
