Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)

Overview of Macroeconomics
We economists don't know much, but we do know how to create a shortage. If you want
to create a shortage of tomatoes, for example, just pass a law that retailers can't sell
tomatoes for more than two cents per pound. Instantly you'll have a tomato shortage. It's
the same with oil or gas.
Milton Friedman, Chicago

Macroeconomics is part of our everyday lives. If the macroeconomy is doing well, jobs
easy to find, incomes are generally rising, and profits of corporations are high. On
other hand, if the macroeconomy is in a slump, new jobs are scarce, incomes are
growing well, and profits are low. Students who entered the job market in the boom of
late 1990s in the United States, on average, had an easier time finding a job than
those who entered in the recession of 20082009. Given the large effect that
macroeconomy can have on our lives, it is important that we understand how it works.

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Differences and similarities between Microeconomics and Macroeconomics:

Microeconomics examines the functioning of individual industries and the behavior of
individual decision-making units, typically firms and households. With a few assumptions
about how these units behave (firms maximize profits; households maximize utility), we
can derive useful conclusions about how markets work and how resources are allocated.
Instead of focusing on the factors that influence the production of particular products and
the behavior of individual industries, macroeconomics focuses on the determinants of
total national output. Macroeconomics studies not household income but national income,
not individual prices but the overall price level. It does not analyze the demand for labor in
the automobile industry but instead total employment in the economy.
Both microeconomics and macroeconomics are concerned with the decisions of
households and firms. Microeconomics deals with individual decisions; macroeconomics
deals with the sum of these individual decisions. Aggregate is used in macroeconomics to
refer to sums. When we speak of aggregate behavior, we mean the behavior of all
households and firms together. We also speak of aggregate consumption and aggregate
investment, which refer to total consumption and total investment in the economy,
respectively.
Because microeconomists and macroeconomists look at the economy from different
perspectives, you might expect that they would reach somewhat different conclusions
about the way the economy behaves. This is true to some extent. Microeconomists
generally conclude that markets work well. They see prices as flexible, adjusting to
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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
maintain equality between quantity supplied and quantity demanded. Macroeconomists,
however, observe that important prices in the economy for example, the wage rate (or
price of labor)often seem sticky. Sticky prices are prices that do not always adjust
rapidly to maintain equality between quantity supplied and quantity demanded.
Microeconomists do not expect to see the quantity of apples supplied exceeding the
quantity of apples demanded because the price of apples is not sticky. On the other hand,
macroeconomists who analyze aggregate behaviorexamine periods of high
unemployment, where the quantity of labor supplied appears to exceed the quantity of
labor demanded. At such times, it appears that wage rates do not adjust fast enough to
equate the quantity of labor supplied and the quantity of labor demanded.

Macroeconomic Concerns:
Three of the major concerns of macroeconomics are

Output growth
Unemployment
Inflation and deflation

Government policy makers would like to have high output growth, low unemployment, and
low inflation. We will see that these goals may conflict with one another and that an
important point in understanding macroeconomics is understanding these conflicts.
Output Growth
Instead of growing at an even rate at all times, economies tend to experience short-term
ups and downs in their performance. The technical name for these ups and downs is the
business cycle. The main measure of how an economy is doing is aggregate real output.
When aggregate output declines, there are fewer goods and services to consume and
average standard of living declines. When firms curtail production, they also lay off
workers, increasing the rate of unemployment.
Recessions are periods during which aggregate output
declines. It has become conventional to classify an
economic downturn as a recession when aggregate
output declines for two consecutive quarters. A prolonged
and deep recession is called a depression, although
economists do not agree on when a recession becomes a
depression. Right after the liberation war back in 1971,
Bangladesh experienced a deep recession. United States of

Figure 1.1:The
business cycle

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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
America and many European nations experienced a prolonged and severe recession back
in 1930s also known as the Great Depression.
During recessions, not only are more people unemployed, but those who are employed
have shorter workweeks, as more workers have to accept part-time jobs and fewer
workers have the opportunity to work overtime. When recessions end and the economy
enters a boom, these effects work in reverse: incomes rise, unemployment falls, and
workweeks expand. Economists call these short-run fluctuations in output and
employment the business cycle. A typical business cycle is illustrated in Figure 1.1. Since
most economies, on average, grow over time, the business cycle in Figure 1.1 shows a
positive trendthe peak (the highest point) of a new business cycle is higher than the
peak of the previous cycle. The period from a trough,or bottom of the cycle, to a peak is
called an expansion or a boom. During an expansion, output and employment grow. The
period from a peak to a trough is called a contraction, recession,or slump, when output
and employment fall.
In judging whether an economy is expanding or contracting, note the difference between
the level of economic activity and its rate of change. If the economy has just left a trough
(point A in Figure 1.1), it will be growing (rate of change is positive), but its level of output
will still be low. If the economy has just started to decline from a peak (point B), it will be
contracting (rate of change is negative), but its level of output will still be high. In 2010
the U.S. economy was expandingit had left the trough of the 20082009 recessionbut
the level of output was still low and many people were still out of work. Many European
nations underwent severe recession in 2007-08, and some are still struggling to
overcome.One the other hand, over the last decade aggregate output of Bangladesh has
been expanding at about 5.5-6% annually!!!
Unemployment
The unemployment ratethe percentage of the labor force that is unemployedis a key
indicator of the economys health. If more people are employed we expect grater amount
of real output or services will be produced. Because the unemployment rate is usually
closely related to the economys aggregate output, announcements of each months new
figure are followed with great interest by economists, politicians, and policy makers.
Although macroeconomists are interested in learning why the unemployment rate has
risen or fallen in a given period, they also try to answer a more basic question: Why is
there any unemployment at all? We do not expect to see zero unemployment. At any time,
some firms may go bankrupt due to competition from rivals, bad management, or bad
luck. Employees of such firms typically are not able to find new jobs immediately, and
while they are looking for work, they will be unemployed. Also, workers entering the labor
market for the first time may require a few weeks or months to find a job.

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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
If we base our analysis on supply and demand, we would expect conditions to change in
response to the existence of unemployed workers. Specifically, when there is
unemployment beyond some minimum amount, there is an excess supply of workersat
the going wage rates, there are people who want to work who cannot find work. In
microeconomic theory, the response to excess supply is a decrease in the price of the
commodity in question and therefore an increase in the quantity demanded, a reduction in
the quantity supplied, and the restoration of equilibrium. With the quantity supplied equal
to the quantity demanded, the market clears.
The existence of unemployment seems to imply that the aggregate labor market is not in
equilibriumthat something prevents the quantity supplied and the quantity demanded
from equating. Why do labor markets not clear when other markets do, or is it that labor
markets are clearing and the unemployment data are reflecting something different? This
is another main concern of macroeconomists.
Inflation and Deflation
Inflation is an increase in the overall price level. Keeping inflation low has long been a goal
of government policy. Especially problematic are hyperinflations, or periods of very rapid
increases in the overall price level.
Most Americans are unaware of what life is like under very high inflation. In some
countries at some times, people were accustomed to prices rising by the day, by the hour,
or even by the minute. Some examples might be helpful: Bolivia and most recently
Zimbabwe have experienced hyperinflation. Box 1. and box 2. Summarize some key facts
of these experiences.

Box 1. Hyperinflation in Bolivia

During the hyperinflation in Bolivia in 1984 and 1985, the price of one egg rose from 3,000
pesos to 10,000 pesos in 1 week. In 1985, three bottles of aspirin sold for the same price
as a luxury car had sold for in 1982. At the same time, the problem of handling money
became a burden. Banks stopped counting depositsa $500 deposit was equivalent to
about 32 million pesos, and it just did not make sense to count a huge sack full of bills.
Bolivias currency, printed in West Germany and England, was the countrys third biggest
import in 1984, surpassed only by wheat and mining equipment.

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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
Box 2. Hyperinflation in Zimbabwe
On April 18, 1980, the Republic of Zimbabwe was born from the former British colony of
Rhodesia. The Rhodesian Dollar was replaced by the Zimbabwe dollar at par value/ face
value. When Zimbabwe gained independence, the Zimbabwean dollar was more valuable
than the US dollar. In its early years, Zimbabwe experienced strong growth and
development. Wheat production for non-drought years was proportionally higher than in
the past. The tobacco industry was thriving as well (which earned almost one-third of
foreign currencies). Economic indicators for the country were strong.
In the 1990s, the Zimbabwean president Robert Mugabe instituted land reforms intended
to redistribute land from white landowners to black farmers to correct the injustices of
colonialism. However, many of these farmers had no experience or training in farming.
From 1999 to 2009, the country experienced a sharp drop in food production and in all
other sectors. Food output capacity fell 45%, manufacturing output 29% in 2005, 26% in
2006 and 28% in 2007, and unemployment rose to 80%.
In addition to that President Mugabe printed more money to finance second Congo War,
giving its army and other officials higher salaries. Another reason to print money is selfdealing or financing corruption. This certainly resulted in the lack of faith in the currency
and the value of currency collapsed.
In June 2008 the annual rate of price growth was 11.2 million percent. The worst of the
inflation occurred in 2008, leading to the abandonment of the currency. The peak month of
hyperinflation occurred in mid-November 2008 with a rate estimated at 79,600,000% per
month.
Adaptations:
Use of Foreign Currencies and Black Markets:
In 2007, the government declared inflation illegal. Anyone who raised the prices for goods
and services was subject to arrest. This amounted to a price freeze, which is usually
ineffective in halting inflation. Officials arrested numerous corporate executives for
changing their prices.
In December 2008, the Central Bank of Zimbabwe licensed around 1,000 shops to deal in
foreign currency. Citizens had increasingly been using foreign currency in daily exchanges,
as local shops stated fewer prices in Zimbabwe dollars because they needed foreign
currency to import foreign goods. Many businesses and street vendors continued to do so
without getting the license.In January 2009, acting Finance Minister Patrick Chinamasa
lifted the restriction to use only Zimbabwean dollars. This too acknowledged what many
were already doing.

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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)

Skyrocketing prices in Bolivia and Zimbabwe are a small part of the story. When inflation
approaches rates of 2,000 percent per year, the economy and the whole organization of a
country begin to break down. Workers may go on strike to demand wage increases in line
with the high inflation rate, and firms may find it hard to secure credit.
Hyperinflations are rare. Nonetheless, economists have devoted much effort to identifying
the costs and consequences of even moderate inflation.

Does anyone gain from inflation?

Who loses?
What costs does inflation impose on society?
How severe are they?
What causes inflation?
What is the best way to stop it?

These are some of the main concerns of macroeconomists.

A decrease in the overall price level is called deflation. In some periods in U.S. history and
recently in Japan, deflation has occurred over an extended period of time. The goal of
policy makers is to avoid prolonged periods of deflation as well as inflation in order to
pursue the macroeconomic goal of stability.
The Components of the Macroeconomy
Understanding how the macroeconomy works can be challenging because a great deal is
going on at one time. Everything seems to affect everything else. To see the big picture, it
is helpful to divide the participants in the economy into four broad groups: (1) households,
(2) firms, (3) the government, and (4) the rest of the world. Households and firms make up
the private sector, the government is the public sector, and the rest of the world is the
foreign sector. These four groups interact in the economy in a variety of ways, many
involving either receiving or paying income.

The Circular Flow Diagram

A useful way of seeing the economic
interactions among the four groups in the
economy is a circular flow diagram, which
shows the income received and payments
made by each group. A simple circular flow
diagram is pictured in Figure 20.3. Let us walk
through the circular flow step by step.
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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
Households work for firms and the government, and they receive wages for their work. Our
diagram shows a flow of wages intohouse-holds as payment for those services.
Households also receive interest on corporate and government bonds and dividends from
firms. Many households receive other payments from the government, such as Social
Security benefits, veterans benefits, and welfare payments. Economists call these kinds of
payments from the government (for which the recipients do not supply goods, services, or
labor) transfer payments. Together, these receipts make up the total income received by
the households.
Households spend by buying goods and services from firms and by paying taxes to the
government. These items make up the total amount paid out by the households. The
difference between the total receipts and the total payments of the households is the
amount that the house-holds save or dissave. If households receive more than they spend,
they saveduring the period. If they receive less
Figure 2. Circular Flow Diagram
than they spend, they dissave. A household can
dissave by using up some of its previous savings or by borrowing. In the circular flow
diagram, household spending is shown as a flow out of households. Saving by households
is sometimes termed a leakage from the circular flow because it withdraws income, or
current purchasing power, from the system.
Firms sell goods and services to households and the government. These sales earn
revenue,which shows up in the circular flow diagram as a flow intothe firm sector. Firms
pay wages, interest, and dividends to households, and firms pay taxes to the government.
These payments areshown flowing outof firmsthe government collects taxes from
households and firms. The government also makes payments. It buys goods and services
from firms, pays wages and interest to households, and makes transfer payments to
households. If the governments revenue is less than its payments, the government is
dissaving.
Finally, households spend some of their income on importsgoods and services produced
in the rest of the world. Similarly, people in foreign countries purchase exportsgoods and
services produced by domestic firms and sold to other countries. One lesson of the circular
flow diagram is that everyones expenditure is someone elses receipt. If you buy a
personal computer from Dell, you make a payment to Dell and Dell receives revenue. If
Dell pays taxes to the government, it has made a payment and the government has
received revenue. Everyones expenditures go somewhere. It is impossible to sell
something with-out there being a buyer, and it is impossible to make a payment without
there being a recipient. Every transaction must have two sides.

The Three Market Arenas

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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
Another way of looking at the ways households, firms, the government, and the rest of the
world relate to one another is to consider the markets in which they interact. We divide the
markets into three broad arenas:

The goods-and-services market,

The labor market, and
The money (financial) market.

Goods and Services Market

Households and the government purchase goods and services from firms in the goodsand-services market. In this market, firms also purchase goods and services from each
other. For example, a local shoe maker buys lace from other companies/ firms. In addition,
firms buy capital goods from other firms. If General Motors needs new robots on its
assembly lines, it may buy them from another firm instead of making them.
Firms supply to the goods-and-services market. Households, the government, and firms
demand from this market. Finally, the rest of the world buys from and sells to the goodsand-services market. Bangladesh imports hundreds of millions of dollars worth of
automobiles, oil, aircrafts and other goods. Bangladesh exports RMG, leather products,
jute, tea and others to many countries.

Labor Market
Interaction in the labor market takes place when firms and the government purchase labor
from households. In this market, households supply labor and firms and the government
demand labor. In any market-based economy, firms are the largest demanders of labor,
although the government is also a substantial employer. The total supply of labor in the
economy depends on the sum of decisions made by households. Individuals must decide
whether to enter the labor force (whether to look for a job at all) and how many hours to
work. Labor is also supplied to and demanded from the rest of the world. In recent years,
the labor market has become an international market. For example, vegetable and fruit
farmers in California would find it very difficult to bring their product to market if it were
not for the labor of migrant farm workers from Mexico. For years, Turkey has provided
Germany with guest workers who are willing to take low-paying jobs that more
prosperous German workers avoid. Call centers run by major U.S. corporations are
sometimes staffed by labor in India and other developing countries.

Money Market
In the money marketsometimes called the financial markethouseholds purchase stocks
and bonds from firms. Households supply funds to this market in the expectation of
earning income in the form of dividends on stocks and interest on bonds. Households also
demand (borrow) funds from this market to finance various purchases. Firms borrow to
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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
build new facilities in the hope of earning more in the future. The government borrows by
issuingbonds. The rest of the world borrows from and lends to the money market. Every
morning thereare reports on TV and radio about the Japanese and British stock markets.
Much of the borrowing and lending of households, firms, the government, and the rest of
the world are coordinatedby financial institutionscommercial banks, savings and loan
associations, insurance companies, and the like. These institutions take deposits from one
group and lend them to others.
When a firm, a household, or the government borrows to finance a purchase, it has an
obligation to pay that loan back, usually at some specified time in the future. Most loans
also involvepayment of interest as a fee for the use of the borrowed funds. When a loan is
made, the borrowerusually signs a promise to repay, or promissory note, and gives itto
the lender. When the federalgovernment borrows, it issues promises called
Treasurybonds,notes,or billsin exchange formoney. Firms can borrow by issuing corporate
bonds.Instead of issuing bonds to raise funds, firms can also issue shares of stock. A share
of stockis a financial instrument that gives the holder a share in the firms ownership and
therefore theright to share in the firms profits. If the firm does well, the value of the stock
increases and thestockholder receives a capital gainon the initial purchase. In addition, the
stock may paydividendsthat is, the firm may return some of its profits directly to its
stockholders instead ofretaining the profits to buy capital. If the firm does poorly, so does
the stockholder. The capitalvalue of the stock may fall, and dividends may not be paid.
Stocks and bonds are simply contracts, or agreements, between parties. I agree to loan
you a certain amount, and you agree to repay me this amount plus something extra at
some future date, or Iagree to buy part ownership in your firm, and you agree to give me a
share of the firms future profits.
A critical variable in the money market is the interest rate. Although we sometimes talkas
if there is only one interest rate, there is never just one interest rate at any time.
Instead,the interest rate on a given loan reflects the length of the loan and the perceived
risk to thelender. A business that is just getting started must pay a higher rate than
General Motorspays. A 30-year mortgage has a different interest rate than a 90-day loan.
Nevertheless, interest rates tend to move up and down together, and their movement
reflects general conditionsin the financial market.
The Role of the Government in the Macroeconomy:
The government plays a major role in the macroeconomy, so a useful way of learning how
themacroeconomy works is to consider how the government uses policy to affect the
economy. Thetwo main policies are (1) fiscal policy and (2) monetary policy. Much of the
study of macroeconomics is learning how fiscal and monetary policies work.
Fiscal Policy:
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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.

Macroeconomics Lecture Series

Lecture 1. (Overview of Macroeconomics)
Fiscal policyrefers to the governments decisions about how much to tax and spend; taxes
and spending are two powerful tools of fiscal policy. The government collects taxes from
households and firms and spends those funds on goods and services ranging from missiles
to parks to Social Security payments to building highways.Taxes take the form of personal
income taxes, Social Security taxes, and corporate profits taxes,among others. An
expansionary fiscal policy is a policy in which taxes are cut and/or government spending
increases. A contractionary fiscal policy is the reverse.
Monetary policy:
Monetary policyin Bangladesh is controlled by Bangladesh Bank,the central bank. The
central bank, as it is usually called, determines the quantity of money in the
economy,which in turn affects interest rates. Central Bankss decisions have important
effects on the economy. The tool of monetary policy is money supply. Monetary policy can,
like fiscal policy, expansionary or contractionary. When Bangladesh bank raises supply of
money then the policy is expansionary and policy of this sort reduces average lending
rate, of the so called interest rate. Lower interest rates then stimulate output and
employment, ceteris paribus. A contractioinary policy has exactly opposite impact as that
of expansionary policy.

References:
G. Mankiew, Macroeconomics, sixth edition
Case and Fair, Principles of Economics, 10th edition

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Mohammad Amzad Hossain
Professor, Dept. of Economics, JU.