Macroeconomics

(With Study Guide CD-ROM)

Jagdish Handa

• Publisher: WSPC
• Year: 2010
• ISBN:
  9789814365239
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

This book presents the stylized facts on the important variables (output, inflation, money supply and interest rates, etc.) of the macro economy and uses them to differentiate how well particular economic theories perform or fail to do so. On the determination of aggregate demand, this book presents two approaches: the traditional IS-LM analysis under the assumption that the money supply is exogenous because the central bank uses its monetary policy to control it, and the emerging IS-IRT analysis under the assumption that the interest rate is the exogenous monetary policy variable set by the central bank to manipulate aggregate demand in the economy. The IS-IRT analysis is important for the macro analyses of many economies, yet is totally neglected in most textbooks on macroeconomics. The chapter on Paradigms in Economics introduces students to the heritage of ideas in macroeconomics, and the evolution of ideas and approaches over the last two centuries. It also provides the justification for the simultaneous relevance of both Classical ideas and Keynesian ones. The two growth theory chapters go beyond the Solow growth model to cover the broad evolution of growth from Malthus's theory to the present endogenous approaches, and the link between money supply, inflation and growth over very long periods.

Errata(s)
Errata
Errata for Study Guide

Contents:

• Introduction to Macroeconomics:
  • Output, Unemployment, and the Basic Concepts
  • Money, Prices, Interest Rates, and Fiscal Deficits
  • Introduction to the Open Economy: Exchange Rates and the Balance of Payments
• Short-Run Macroeconomics:
  • Determinants of Aggregate Demand: The Commodity Market of the Closed Economy
  • Aggregate Demand in the Open Economy Under an Interest Rate Target: IS-IRT Analysis
  • Aggregate Demand Under a Money Supply Operating Target: IS-LM Analysis
  • Full-Employment Output and the Natural Rate of Unemployment
  • Output in the Short Run: The Role of Expectations and Adjustment Costs
  • Actual Output, Disequilibrium, and the Interaction Among Markets
  • Employment, Unemployment, and Inflation
  • Paradigms in Macroeconomics
• Topics in Open Economy Macroeconomics:
  • The Foreign Exchange Market, IMF, and Globalization
  • The Open Economy Under a Fixed Exchange Rate Regime
• Growth Economics:
  • Classical Growth Theory
  • Advanced Topics in Growth Theory
  • Business Cycles, Crises, and The International Transmission of Economic Activity

Readership: Undergraduate college and university courses in macroeconomics.

PART I

Introduction to Macroeconomics

CHAPTER 1

Output, Unemployment, and the Basic Concepts

Macroeconomics studies the functioning of the economy at the aggregative level. It encompasses the study of the economy when it is performing at its optimal level as well as when it has deviations from this level. In both cases, macroeconomics examines whether the economy’s performance can be improved through the use of monetary, fiscal, and other governmental policies.

The fundamental questions of macroeconomics concern the levels of output and its rate of growth, unemployment and inflation in the economy, and changes in them. Their determination is studied in the contexts of the short run and the long run .

Economics is a science. It builds theories to explain the real-world, real-time observations on its variables of interest and subjects the predictions of its theories to statistical tests through the use of econometrics .

1.1 Introduction to Macroeconomics

Macroeconomics is the study of the functioning of the economy at the macro or aggregative level. Its main variables of interest are:

• output and the standard of living,

• unemployment,

• the price level and inflation,

• interest rates and the money supply,

• balance of payments and exchange rates,

• the impact of government expenditures, taxes, and deficits on the economy, and

• the central bank’s policies on money supply and interest rates and their impact on the economy.

A proper study of these topics involves the study of numerous other variables. Among these are wages, consumption, saving and investment, exports and imports, capital flows between countries, labor demand and supply, money demand and supply, etc.

1.1.1 The nature of macroeconomic analysis

A general study of the whole economy can be formulated in two distinct ways:

i. As a general equilibrium microeconomic model.
This formulation includes a separate specification of the market for each good, as in microeconomic analysis. Such a system is a very detailed one, studying as it does the separate demand, supply, and price of each good in the economy. It is, however, quite cumbersome for macroeconomic purposes where the objective is to focus on a few macroeconomic variables only.

ii. As a macroeconomic model.
Such a model aggregates the very large number of goods in the economy into a small number of categories. This formulation reduces the number of goods and their markets to be studied to a manageable level. Obviously, the degree of aggregation used must depend upon the intended use of the resulting model or framework.

The classification of goods in macroeconomics

Short-run macroeconomics normally classifies all goods in the economy into five categories.

1. commodities (commonly known as ‘goods and services’),

2. money (i.e., currency and demand deposits),

3. bonds (i.e., non-monetary financial assets, so that the term ‘bonds’ in macroeconomics includes equities),

4. labour,

5. foreign exchange (mainly foreign currencies and gold).

Closed economy versus open economy analysis

For heuristic reasons, macroeconomics is often first presented in closed economy models that are later extended to the open economy. A closed economy is one that does not have international trade in commodities or capital flows with other countries. An open economy is one that has such linkages. These linkages imply an additional degree of complication of analysis, so that one needs to master the closed economy models to better understand the open economy ones.

The closed economy macroeconomic models analyze the markets for four goods: commodities, money, bonds, and labor, and assume that there is no trade in these between the domestic economy and foreign ones. The open economy models of macroeconomics assume that there is trade in the above four goods between the domestic and foreign economies. They also include the analysis of the market for foreign exchange.

Short-run macroeconomic theories, growth theories and business cycle theories

The main focus of the short-run macroeconomic theories is on the impact of shocks to the macro economy and the effects of fiscal, monetary, and other policies on aggregate output, unemployment, and the other variables of interest mentioned above. The main focus of growth theories is on the long-run evolution of the total output of the economy and of the standard of living. The main focus of business cycle theories is on the variations in output and unemployment, inflation and interest rates over the business cycle.

1.2 The Classification of Economic Agents and Markets in Short-Run Macroeconomic Models

Macroeconomics treats labor as an input in the production of commodities, whose purchase for consumption or investment is transacted with money as a medium of exchange/payments. Labor is provided by workers/households who receive wages as payment for the work. Households receive not only wages but also interest and profits from their ownership of physical capital (including land and housing). The sum of these receipts constitutes national income. The demands for domestic and imported commodities (including physical capital), bonds (non-monetary financial assets), and money depend on national income (which is generated by production) and national wealth.

The basic classification of economic units in the economy is into:

• Households, which supply labor as workers and are the owners of capital. They receive wages and profits (or interest) from their ownership of capital, and decide on consumption, saving, and money and bond holdings.

• Firms, which engage in the production of output by hiring labor (and any other inputs) to use with their capital. They incur investment to change their capital stock, and issue bonds (including equities) to finance their investment. Financial institutions, such as banks, are firms under this classification. Firms are assumed to maximize profits.

• While non-government organizations (NGOs)¹ usually do not attempt to maximize profits, macroeconomic analysis, for simplification, does not include their separate analysis and just lumps them in the category of firms.

• The government (‘the fiscal authority’), which decides on the government expenditures and taxes. It finances its fiscal deficits by raising funds in the financial markets by selling bonds to the public. It uses fiscal surpluses to buy back some of its (outstanding) bonds from the public. In contrast with firms, it is not assumed to be a profit-maximizer.

• The central bank (‘the monetary authority’), which decides on the money supply and interest rates.

• Foreign economies, which trade in commodities (as exports and imports) and bonds (which result in financial capital flows between the foreign and the domestic economies). These flows of commodities and financial capital are captured in the balance of payments. The amount of foreign currencies, foreign bonds, and gold held by the country are the major part of its foreign exchange reserves and the exchange rate is the rate of exchange between the domestic currency and foreign ones.

As mentioned earlier, there are five distinct, composite goods in macroeconomic analysis: commodities (including physical capital), bonds, money, labor, and foreign exchange. Their ‘markets’ are referred to as markets or sectors, the two terms being used interchangeably. Therefore, the macroeconomic model has five markets:

1. the commodity (or product) market,

2. the money market,

3. the financial (i.e., bonds, and equities) market,

4. the production-employment sector composed of the labor market and the production function, and

5. the foreign exchange market, whose analysis captures payment flows occurring due to the country’s economic exchanges with the rest of the world.

The specification of each market requires (i) its demand function, (ii) its supply function, and (iii) an equilibrium condition.

Only the first four markets are studied for the closed economy – that is, an economy that does not have commodity or capital flows with other countries. Virtually all countries now have an open economy – that is, an economy with exchanges of goods with other economies. The common procedure in macroeconomics is to first build models for the closed economy and then to modify them to capture the open economy elements.

Box 1.1: The Analytical Devices of the Short-Run Versus Long-Run Analysis

Macroeconomics separates the forces that operate on economic variables into long-run ones and short-run ones. The long run is an analytical (not chronological) period during which all variables are free to change and there are no adjustment costs. The short run is an analytical (again, not chronological) period during which some variables are fixed in value and/or there are costs to adjusting them. The main differences between the short-run and the long-run analysis are: the long run allows changes in the physical capital stock, population, and technology, while the short run holds them constant (fixed).

The analytical distinction between the long run and short run is used to distinguish between economic forces that mainly operate over longer periods and those that operate mainly over shorter periods. The analytical device of the long run is especially useful for the analysis of the growth of output and standards of living over long periods. The analytical device of the short run is especially useful for the analysis of several variables of topical interest: differences in the actual rate of output from its long-run potential, unemployment, interest rates, inflation, balance of payments, exchange rates, etc. The short-run analysis constitutes the greater part of the theories in macroeconomics. Most of the chapters of this book present the short-run theories.

Real Time Concepts: The Short Term and the Long Term

The corresponding chronological concepts in real time are the long term and the short term. The short term is sometimes used to cover a period as short as the current quarter and sometimes a period as long as the business cycle, which can run for about ten years. The long term is taken to cover a period of several years.

The correspondence between the long term and the long run is vague and ambiguous, as is that between the short run and the short term. In general, the long run embodies economic forces that operate all the time, even during the short term. Similarly, the short run incorporates economic forces that operate not only in the short term but will also be in evidence in the economy over long chronological periods since a long chronological period incorporates a sequence of short runs.

Business cycles occur in real time. Their explanation incorporates both short-run and long-run forces.

1.3 Introduction to AD-AS Analysis

The dominant concern of macroeconomics is with the determination of the economy’s marketed output — defined so as to include that provided by firms, government, and non-government organizations (NGOs)—as well as the r...

Table of contents

• Cover Page
• Title Page
• Copyright
• Dedication
• Contents
• Preface
• About the Author
• Glossary of Symbols
• Part I Introduction to Macroeconomics
• 1 Output, Unemployment, and the Basic Concepts
• 2 Money, Prices, Interest Rates, and Fiscal Deficits
• 3 Introduction to the Open Economy: Exchange Rates and the Balance of Payments
• Part II Short-run Macroeconomics
• 4 Determinants of Aggregate Demand: The Commodity Market of the Closed Economy
• 5 Aggregate Demand in the Open Economy under an Interest Rate Target: Is-IRT Analysis
• 6 Aggregate Demand Under a Money Supply Operating Target: IS-LM Analysis
• 7 Full-Employment Output and the Natural Rate of Unemployment
• 8 Output in the Short Run: The Role of Expectations and Adjustment Costs
• 9 Actual Output, Disequilibrium, and the Interaction among Markets
• 10 Employment, Unemployment, and Inflation
• 11 Paradigms in Macroeconomics
• Part III Topics in Open Economy Macroeconomics
• 12 The Foreign Exchange Market, IMF, and Globalization
• 13 The Open Economy Under a Fixed Exchange Rate Regime
• Part IV Growth Economics
• 14 Classical Growth Theory
• 15 Advanced Topics in Growth Theory
• 16 Business Cycles, Crises, and The International Transmission of Economic Activity
• Index