Session 01: Introduction to Macroeconomics PDF

Session 01: Introduction to Macroeconomics Session 01 Introduction to Macroeconomics Contents Introduction 1.1 Macroeconomics 1.2 Macroeconomic Goals 1.3 National Income, Inflation, Employment, Fiscal and Monetary Policy 1.4 Aggregate economic...

Session 01: Introduction to Macroeconomics Session 01 Introduction to Macroeconomics Contents Introduction 1.1 Macroeconomics 1.2 Macroeconomic Goals 1.3 National Income, Inflation, Employment, Fiscal and Monetary Policy 1.4 Aggregate economic behaviour Review Question Learning Outcomes Introduction Economic is usually separated into two general areas, Micro economics and Macroeconomics. Microeconomics is the study of economics at the level of the individual economic entity: the individual firm, the individual consumer, and the individual worker. Macroeconomics is the study of the economy at an aggregate level. Rather than analysing he behaviour of an individual consumer or firm, macroeconomics look at the sum of the behaviour of all consumer (the consumer sector) and all firms (the business sector)as well as the government and international sectors. Our present interest in presenting this courses material, to you, largely springs from this consideration. In other words study of macro- economic forms an essential part of the Management Studies Programme. 1 Unit I: Introduction to Macroeconomics This is the second course in the three courses of economics. This volume initially covers the four macro areas, namely, the Household sector, the Government sector, the Business sector and the International sector. This lesson introduces the main features of macroeconomics with some examples that we need to study macro- economics in a management study programme. Study guide This lesson introduces the main features of macroeconomics. You may allocate about 3-4 hours to complete this lesson. Before reading this lesson, make sure you know the meaning of: Macroeconomics, the basic economic problem, caused by scarce resources, and unlimited wants. 1.1 What is Macroeconomics? Macro-economic studies the behaviour of the whole economy of a country by focusing on leading economic aggregates such as national Income, employment, consumption and investment, general price level, and the role of fiscal and monetary policy in the economy. Aggregate trade flows of a country, exports, imports, international payment and the resulting balance of payment and the exchange rate & their respective changes fall within the frame work of macro-economics. These economic aggregates that we study in macro- economic indicate the activities in many different markets in the economy, which in turn reflect the behaviours of different groups of persons and organizations in the country, such as consumer or households, the government, the business firms and the banks. Thus, the leading aggregates, that macro-economic concentrates on such as national product level of employment, national income, total savings 2  Session 01: Introduction to Macroeconomics investment, taxation & price level in an economy are the results of economic activities of these broad groups of persons or organizations. These factors of the economy are measured during a specific time period, usually one year. Macroeconomics deals with economic affairs in the large, it concerns the overall dimensions of economic life, it looks at the total size and shape and functioning of the “elephant” of economic experience, rather than working of articulation or dimensions of the individual parts. Activity 1.1 “Macroeconomics focuses on sectors of the economy but not those that function as separate units”. Explain. 1.1.1 Justification for the study of Macroeconomics Macroeconomics, attempts to answer truly big questions of economics life as we mentioned earlier. As a result macroeconomics can describe and assess the current economic state of a nation The leading macroeconomic indicators are the level and rate of growth of total and per capita output, the level of employment and the unemployment rate, inflation rate (changes in general price level) the interest rate, the state of the balance of payment and the external value of national currency (exchange rate). They reflect the economic status of a nation and serve many people differently. Study of macroeconomics is fascinating apart from being highly useful. For instance, economists formulate theories based on changes and observed relationship, politicians’ use them for propaganda and publicity, administrators use them to assess and evaluate policy shifts and formulate new economic policies and business firms use them for their crucial decisions and planning. The members of the general public can also use 3 Unit I: Introduction to Macroeconomics them in making decisions relating to spending, saving or house building and assessing the performance of governments as voters. These considerations generally determine the justification for the study of macroeconomics. 1.1.2 Why Macroeconomics should be studies by Business Managers For business managers changes in the macro-economy as shown by the leading indicators of macro-aggregates are vital to their decisions and planning. A proper understanding of macro-economic variables and their changes can give a business manager, a better vision of understanding his business environment. The ebb, and the flow of the economy, (the business cycle) macro – economic studies vitally affect. Business activities and managers understanding of macro - economy can provide the information and knowledge for better understanding of future market trends, prices and cost changes , risk and uncertainty factors. Activity 1.2 Suppose you are a manager of “X” company. Do you think that macroeconomics variables would help you to make any economic decisions on your business environment? 1.2 Macroeconomics Goals In economic analysis, issues such as growth, full employment and price stability are crucially important.In the case of macroeconomic analysis, economists have specified criteria like i. Economic stability and growth ii. Full employment iii. Price stability 4  Session 01: Introduction to Macroeconomics 1.2.1 What is economic stability High levels of production and its sustained growth are among the most important goals of any economy. Here the stability in real output means the maintenance of output levels without wide fluctuations. However, macroeconomics seeks to explain why fluctuations happen and to evolve policies to address and counter them. Because drastic economic fluctuations may lead to a decline in the Gross National Product (GNP), economists try to prevent such fluctuations through macroeconomic management. 1.2.2 What is full employment? The term full employment includes both labor, and other factors of production. The idea is that in an economy, all the production factors such as land, labor, capital, entrepreneurship should be fully utilized. The under- utilization of any of the above factors can lead to many economic and social problems. Therefore, economists have focused their macro-economic analysis on how an economy can achieve full employment through macroeconomic management. “Full employment of national income” implies a mobilization of the real value of all goods and services that can be produced when a country’s factors of production are fully employed – when the economy is at the natural rate of unemployment. 1.2.3 What is price stability Frequent fluctuations in general price levels can be harmful to most agents engaged in economic activities. Therefore, macroeconomics tries to keep general price levels stable. Price stability here does not mean a fixed price level on a permanent basis. It is possible to have changes in the price levels in the long- run. Economists try to measure the price stability using price indices, such as consumer price index, wholesale price index and GNP deflator. By keeping these indices at reasonable level economists can maintain the macroeconomic goal of price stability. 5 Unit I: Introduction to Macroeconomics During the past 30 years, economists have paid special attention to achieving the above macroeconomic goals by focusing attention on national income, balance of payment equilibrium, inflation and employment. In this regard, actions with respect to fiscal policy, monetary policy and exchange rate have also been very effective. 1.3 Aggregate economic behaviours In many instances macroeconomics discusses the aggregate economic behaviour rather than the behaviour of individual households or firms. To answer the above questions, we need to know some basic facts about the macro economy. Specifically,  How much output do we produce in a year?  How much income is generated from the production of these goods and services?  Where does all the output and income go? The measurement of aggregate economic activity - national income-serves two basic functions.First, it enables us to identify economic problems. The second function of national income is to provide an objective basis for evaluating policy. The following section deals with the aggregate economic behaviour of an economy. In order to simplify the economic complexities of the real world, economists construct models. For instance, in analysing the level of aggregate1 output, it may be useful to divide the economy into the following spending sectors, household, business, government and international. Once the spending behaviour of each sector is specified, the economists are able to predict the level of aggregate output. The following chart, Figure 1 shows the spending of each of the sectors, and how they determine the value of goods and services produced by the economy. 6  Session 01: Introduction to Macroeconomics Disposable income is the amount of income that people have to spend after taxes (Yd). Definition of the household sector, Business sector, Government sector and international sector are given in annexure 1. Figure 1.1: Value of goods & services produced by four sectors 1.4 Selected Issues of macro economics After we have seen the scope and the subject matter of macro- economics and noted why we need to study macro-economics in a management study programme, let us look at some of the issues that macro - economics study and seek to find explanations. 1.4.1 National Income National Income is the total of goods and services produced by a nation in a year. National income is one of the most important concepts in macroeconomic analysis. The National income (N) explains, to a great extent, the behaviour of other macroeconomic variables. 7 Unit I: Introduction to Macroeconomics To clarify the operations of the National economy, economists usually group individual buyer and seller into four sectors: (a) households (b) businesses (c) government and (d) international sector. Since, every economy affects, and is affected by the rest of the world, to understand how the economy functions we must include the international sector. (a) Household sector A household is an economic unit (consisting of one or more persons) which provides the economy with resources. It uses the money earned to purchase goods and services.In macroeconomic analysis, we consider all household in a country as one sector. This sector takes its independent decisions with respect to spending its income, because these householders provide their land. Labour, capital and entrepreneurship to words the production process. For example a member of a house hold may be a Wage earner; similarly a member can earn some income by giving his land for rent. Another household can invest his money as capital and earn an interest. Likewise if all the householders are engaged in such activities we can say that the household sector aggregatively provides the production factors for the business sector.So if we add the economics of all the households, that aggregate can be regarded as the household sector income. (b) Business sector In the analysis of national income, we have identified the business sector as the place where goods and services are produced using production factors like land, labour, capital, etc., provided by the household sector. As we explained earlier the household sector provides the factor of production for manufacturing. The business sector pays wags, rent, interest and earned a profit from their services. At the same time output of the business sector may be purchased again by the household sector using their earned money in the production process. 8  Session 01: Introduction to Macroeconomics (c) Government Sector The government and public sector plays a very important role in any economy. For macroeconomic models, government sector expenditure comes as an outside variable or exogenous variable. In the Quinicine model the government sector expenditure largely determines the equilibrium level of national income. In particular, the government’s handling of its expenditure as an element of fiscal policy, is considered one of the main method of insuring that national income is at its optimum level. (d) International sector The economic relations between nations differ from economic relations within nations. Most nations of the world export goods, services and factors of production in exchange for imports. For example Sri Lanka exports tea and imports petroleum from the Middle-East countries. Thus, a great many economic transactions take place between countries. These transactions could result in either favourable or unfavourable trade balances. 1.4.2 Business cycle The business cycle (Trade cycle) is a well-observed economic phenomenon; it often occurs on a generally upward growth path and has a variable time span, typically of the order of five years. The cycle of booms and recessions in the economy is called business cycle because it corresponds closely to the level of business activities in the economy. During a boom business activities generally prosper when the economy registers rising employment, production, and incomes of people, together with increasing aggregate demand. During a recession, when the economy registers a fall in these same businessman experiencing depressed demand conditions in the economy during such periods, take a gloomy view of the economy and do not plan to invest and expand their business activities, the economy further declines in the wake of such negative expectations of the business 9 Unit I: Introduction to Macroeconomics community. Within a year or two when a revival of business people’s expectations take place, then the economy recovers and swings back to another boom. This would last for few years to be followed by a recession again. This succession of booms and recession, brings with it disruptions to the economy in the form of loss of incomes and employment and causes widespread misery among people. For example in 1930 there was a worldwide economic depression causing widespread unemployment in all developed countries. This prompted many economists to question why the economic depression occurred spreading wide spread unemployment and misery in the western economic world, when the then accepted orthodox economic theory [The classical economic theory] postulated a full employment situation. In fact the very birth of macro-economics as a branch of economics can be traced to the World Depression of 1930s and the pioneering work of the British economist, John Murrey and Keynes. In his book the general theory of employment interest and money is most outstanding in producing a new insight into the working of the whole economy (macro economy) and the possible causes of booms and recessions in it. 1.4.3 Inflation This is probably the most important issue in macro- economics. It is so because it affects a larger section of the people in a country. Hence it receives wide publicity in news media and tends to act as a barometer to evaluate government’s fiscal and monetary policies. Inflation (or deflation, opposite of inflation) refers to a continual increase (or decrease) in the general price level as an average of the prices of all goods and services in an economy. When there is a continual upward increment of the general price level, there is inflation in the economy, and conversely in a deflation, the movement in the general price level is downward. 10  Session 01: Introduction to Macroeconomics During times of inflation, when price levels in an economy rise, more money (Rs or dollars) are required to buy a standard collection (basket) of goods. What this really means is that the purchasing power of money which is the inverse of general price level (1/p) drops, indicating that fewer goods and services would be bought for a unit of money, for example for Rs 50 S 10.00. This is how inflation or declining purchasing power of money affects most consumers and house holders in an economy. Generally inflation affects different groups of income receivers differently. Those who receive fixed incomes fixed by contractual arrangements such as salaried employees, retired pensioners, creditors and the like would experience lower buying power that adversely affect their living standards. On the other hand those who receive raised incomes which are influenced by price levels would experience enhanced incomes, receipts. Generally those who are engaged in retailing and other types of selling would stand to benefit from rising prices. Though the view is generally held that inflation tends to favour business community whose income receipts may rise with rising prices we must not forget the fact that inflation may raise costs as well and thereby squeeze profit margins as well. In any case an inflationary situation signifies uncertainty of prices and this is not helpful to the business community for future planning. 1.4.4 Unemployment Another important issue that macro-economic studies are the issue of unemployment. It is also an issue that concerns the business community because high level of unemployment in the economy is not conducive for business expansion. Such conditions indicate a depressed demand situation generally speaking a downturn in the economy (a recessionary condition) causes an increase in unemployment. This situation brings about depressed demand conditions in the economy and this is not helpful to business expansion and or new business ventures. 11 Unit I: Introduction to Macroeconomics The solution for widespread unemployment is to promote economic development and carefully manage aggregate demand factors to induce the economy to recover and finally to proceed on an expansionary path. The pioneering work of J M Keynes in the 1930s referred to earlier basically addresses the issue of widespread unemployment. In providing a theoretical explanation of the macro- economy of England, Keynes showed how a government can and should manage a macro economy of a country to achieve full employment in order to avoid widespread unemployment as witnessed in the United Kingdom and the US during the depression years of 1930. As the analysis of the macro-economy developed by Keynes in The General Theory was focused mainly on the demand factors of the economy, the Keynes theory of aggregate demand management in the economy towards achieving full employment. Hence Keynesian economic management principles and guide lines have had a profound influence on the conduct of government fiscal and monetary policies in countries like the UK, the USA and elsewhere. Influenced by Keynes theory the solution for unemployment in 1930s was for the government to increase their spending or reduce taxes. Though this policy prescription was largely dictated by the depression conditions of 1930s, today there is concern about government running a budget deficit and thereby increasing it’s spending to create jobs. The concern is about the potential burden of public debt resulting from budget deficits and about interest payments that tax payers have to bear on increasing public debt and increase taxes. Today’s controversy over the government budget has emerged as a central macro-economic issue. The question is raised whether it is good for a government to run budget deficits? or should there be some limit to budget deficits? Will not the economy be healthier if governments aim for balanced budgets or can the recession be alleviated if governments deliberately run budget deficits most of the time. These crucial issues relating to macro- economic management through fiscal and monetary policies of the 12  Session 01: Introduction to Macroeconomics government have come to the forefront in the controversy regarding the role of government in the economy. 1.4.5 Fiscal and Monetary Policy Fiscal policy is the government’s policy with regard to spending and taxation. By varying the level of government spending, policy makers can affect the level of income in the economy. When a government increases spending, it stimulates the economy, raising aggregate expenditure and income. When a government decreases spending, it depresses the economy, reducing aggregate expenditures and income. For instance a recessionary gap can be closed by increasing government spending. Of course government spending is only part of fiscal policy. Changes in taxes also have an effect on macroeconomic equilibrium. Most of us never think about how money enter the economy. All we worry about is having money available when we need it. In the lesson, you will learn about money and how bankers create money by making loans. The quantity of money is a measure of what individuals and businesses have available for spending. So money affects prices, interest rates, foreign exchange rates and the level of income in the economy. Because money is so important, every government control the size of its money supply. In Sri Lanka, the central bank is responsible for monetary policy. You may find more details about this in the coming lessons. 1.4.6 Economic Growth Economic growth is an important macroeconomic goal as price stability and employment. Economic growth is an indicator which measures, the performance of the National income. For instance why has China’s GNP grown at a faster rate in recent decades than those of other countries? Why and how? Understanding why and how economic growth happens is a very important part of macroeconomics. Yet the rate at which national income grows is very different in different countries. What factors cause economies 13 Unit I: Introduction to Macroeconomics to grow and living standards to rise? Answer to this question will be met in a subsequent lesson. Review Questions 1. Define these terms:  National income  Inflation  Employment  Business Cycle  Economic Growth 2. Why is it important for you (manager) to study macroeconomics? 3. What is the difference between micro & macroeconomics?  Give two examples of each. 4. What are the three goals of macroeconomic policy? 5. How do the four sectors interact in the economy? 6. “Macroeconomics is the study of the overall economy” Explain. Learning Outcomes When you complete this lesson you should be able  To define what is macroeconomics.  To explain the concepts of macroeconomics.  To describe the overall goals of macroeconomic policy such as growth, full employment and price stability.  To apply the macroeconomics concept into the management environment. 14