Essence of macroeconomics

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  • 1. Essence of MacroeconomicsMacroeconomics is concerned with behavior of the economy as a whole. Itanswers the questions regarding growth of output, rates of inflation andunemployment, Balance of Payments and exchange rates and also methodsto improve the economy. It deals with both the Long-run economic growthand the short run fluctuations that constitute the business cycle.Macroeconomics encapsulated in three models:The study of macroeconomics is organized around three models taking intoaccount 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 fromtrend growth. There are peaks and troughs. Peaks arecyclical deviations where economic activity is highrelative to trend. Cyclical troughs are the low points inthe economic activity. Output gap measures a gapbetween actual output and trend or full employment orpotential output. The output gap falls during recessionand conversely increases during an expansion. Apositive gap means overheating of the economy.Inflation and Business Cycle: Increase in inflation ispositively related to the output gap. Expansionaryaggregate demand policies tend to produce inflation.Protracted periods of low aggregate demand tend toreduce the inflation rates. Inflation is a majormacroeconomic concern. In case of unemployment,potential output is going to be waste. In case ofinflation there is no obvious loss of output. Howeverinflation reduces the efficiency of the price system.Policy makers therefore increase unemployment(reduced output) in an effort to reduce inflation. This isknown as growth inflation trade-off.