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CHAPTER ONE
INTRODUCTION

1.1. DEFINITION AND SCOPE OF ECONOMICS

The word ‘Economics’ originates from the Greek work ‘Oikonomikos’ which can be
divided into two parts:
1. ‘Oikos’, which means ‘Home’, and
2. ‘Nomos’, which means ‘Management’.
Thus, Economics means ‘Home Management’. The head of a family faces the
problem of managing the unlimited wants of the family members within the limited
income of the family. In fact, the same is true for a society also. If we consider the
whole society as a ‘family’, then the society also faces the problem of tackling
unlimited wants of the members of the society with the limited resources available
in that society.

Therefore, Economics is the study of the way in which mankind organizes itself to
tackle the basic problems of scarcity. All societies have more wants than resources.
Hence, a system must be devised to allocate these resources between competing
ends.

The separate treatment of Economics has accounted more than 200 years right
from the book “The Nature and Causes of Wealth of Nations (1776)” who
regarded as father of Economics.
 Before the innovative book of Adam Smith, there was not a separate field of
study of economics.
 Rather Economic ideas were found in a fragmented manner coupled with
religion and ethics.

Political economy was the earlier name for the subject, but economists in the late
19th century suggested 'economics' as a shorter term for 'economic science' that
also avoided a narrow political-interest connotation and as similar in form to
'mathematics', 'ethics', and so forth.

Different economists define economics in different ways. The definition of

economics has encountered so many controversies. The reason behind is the
economy in general is dynamic and subject to frequent changes, likewise is the
subject matter of Economics.

The most agreed up on definition of Economics is: “the study of the efficient
allocation of scarce resources (which often do have alternative uses) in the
production, distribution &consumption of goods and services, so as to attain the
maximum fulfillment of unlimited human wants or needs”.

The above definition of economics clearly indicates that there are two fundamental
facts which are the foundation for the field of economics.
 The first fact is: human wants (needs) are unlimited.
 The second fact is: economic resources -the means of producing goods and
services are limited in supply or scarce.

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With human wants being unlimited and resources being scarce, it is impossible to
satisfy all our wants and desires by producing everything we want. Thus, a society
has to decide to efficiently use its scarce resources and to obtain the maximum
possible satisfaction from it. This is the central concern of the subject matter of
economics.

NATURE OF ECONOMICS
Economics is both a science and an art.
Economics is a science: A subject is considered science if
 It is a systematized body of knowledge which studies the relationship
between cause and effect.
 It is capable of measurement.
 It has its own methodological apparatus.
 It should have the ability to forecast.

If we analyze Economics, we find that it has all the features of science. Like science
it studies cause and effect relationship between economic phenomena. To
understand, let us take the law of demand. It explains the cause and effect
relationship between price and demand for a commodity.
 It says, given other things constant, as price rises, the demand for a
commodity falls and vice versa. Here the cause is price and the effect is fall
in quantity demanded.
 Similarly like science it is capable of being measured, the measurement is in
terms of money.
 It has its own methodology of study (induction and deduction) and
 It forecasts the future market condition with the help of various statistical and
non-statistical tools.

But it is to be noted that Economics is not a perfect science. This is because

Economists do not have uniform opinion about a particular event. The subject
matter of Economics is the economic behavior of man which is highly unpredictable.

Economics is an art: Art is nothing but practice of knowledge.

 Whereas science teaches us to know art teaches us to do.
 Unlike science which is theoretical, art is practical.

If we analyze Economics, we find that it has the features of an art also. It helps in
solving various economic problems which we face in our day-to-day life. Thus,
Economics is science in its methodology and art in its application.

POSITIVE & NORMATIVE SCIENCE

Positive economics is the branch of economics that concerns the description and
explanation of economic phenomena.

 It focuses on facts and cause-and-effect behavioral relationships and includes

the development and testing of economics theories.
 Earlier terms were value-free economics. Positive economics, as science,
concerns analysis of economic behavior.

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 Positive economics as such avoids economic value judgments’. For example,

a positive economic theory might describe how money supply growth affects
inflation, but it does not provide any instruction on what policyought to be fol-
lowed.

Normative economics is also a part of economics that expresses value judgments

(normative judgments) about economic fairness or what the economy ought to be
like or what goals of public policy ought to be.

Positive economics is commonly deemed necessary for the ranking of economic

policies or outcomes as to acceptability, which is normative economics. Positive
economics is sometimes defined as the economics of "what is", whereas normative
economics discusses "what ought to be".

BRANCHES OF ECONOMICS
Economic theory, as it stands today, has several branches. Of these, two are most
important. These are microeconomics and macroeconomics. We shall now briefly
mention the major features of these two branches to have an idea regarding the
nature of economics.

Microeconomics is a branch of economics that studies the behavior of individual

households and firms in making decisions on the allocation of limited resources.
 Microeconomics examines how these decisions and behaviors affect the
supply and demand for goods and services, which determines prices, and
how prices, in turn, determine the quantity supplied and quantity demanded
of goods and services.
 How does an individual (or a family) decide on how much of various
commodities and services to consume? How does a business firm decide how
much of its product (or products) to produce? These are the typical questions
discussed in microeconomics. Determination of income, employment, etc. in
the economic system as a whole is not the concern of microeconomics.
 Thus, microeconomics can be defined as the study of economic decision-
making by micro-units.
 It is known as price theory (since it explains the process of allocation of
economic resources along alternative lines of production on the basis of
relative prices of various goods and services.)

Macroeconomics is a branch of economics dealing with the performance,

structure, behavior, and decision-making of an economy as a whole, rather than
individual markets. This includes national, regional, and global economies.
 Macroeconomists study aggregated indicators such as GDP, unemployment
rates, and price indices to understand how the whole economy functions.
 Macroeconomists develop models that explain the relationship between such
factors as national income, output, consumption, unemployment, inflation,
savings, investment, international trade and international finance.
 In simple words, “Macroeconomics deals ... not with individual income but
with national income, not with individual prices but with the price level, not
with individual outputs but with national output”.
 It is also known as the income theory (since it explains the changing levels
of national income in any economy during any particular time period.)

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1.2. INTRODUCTION TO MACROECONOMICS

DEFINITIONS
Macroeconomics is a branch of economics that deals with economic aggregates like
national income, employment, aggregate consumption, savings and investment,
general price level, and balance- of- payments position.
 Macroeconomics is a policy-oriented part of economics. The subject matter of
macroeconomics includes factors that determines both the level of
macroeconomic variables such as: total output, aggregate price level,
employment and unemployment, interest rates, wage rates and foreign
exchange rates etc and how the variables are change over time.

The role of making economic policy falls to World leaders, but the job of explaining
how the economy as whole works falls to Macroeconomists.

Macroeconomists collect data on different variables from different time periods and
different countries. They, then, attempt to formulate general theories that help to
explain these data.

In macroeconomics, we do two things.

 First, we seek to understand the economic functioning of the world we live
in; and,
 Second, we ask if we can do anything to improve the performance of the
economy.

That is, we are concerned with both explanation and policy prescriptions.

EVOLUTION
 With the Great Depression of the 1930s the field of macroeconomics began to
expand. Particularly influential were the ideas of John Maynard Keynes, who
used the concept of aggregate demand to explain fluctuations in output and
unemployment.
 Before great depression Classical economists believed that markets would
adjust quickly and direct the economy toward full employment. The huge
decline in output, prolonged unemployment, and lengthy duration of the
Great Depression undermined the classical view and provided the foundation
for Keynesian economics.
 The classical economists used microeconomic models to economy wide
problems. They assume that via forces of demand and supply it is possible to
attain equilibrium.
 Keynes, however, argued that wages and prices were highly inflexible,
particularly in a downward direction. Thus, he did not think changes in prices
and interest rates would direct the economy back to full employment

PURPOSE OF STUDYING MACROECONOMICS

 Wisely allocating scarce resources to satisfy the unlimited human wants
 Efficiently managing your business, since it deals about price, cost, profit,
market, production, saving, investment etc
 A better understanding of the economic problems of societies ,such as rising
unemployment, inflation, budget deficit, external debt, economic growth etc

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 Formulating and developing different policies that might prevent or correct

such problems

MAJOR ELEMENTS OF MACROECONOMICS

1. MAIN MACROECONOMIC VARIABLES
Economic growth:is the increase in the amount of the goods and services
produced by an economy over time.

 It is conventionally measured as the percent rate of increase in real

gross domestic product, or real GDP. Growth is usually calculated in
real terms, i.e. inflation-adjusted terms, in order to obviate the
distorting effect of inflation on the price of the goods and services
produced.

 In economics, "economic growth" or "economic growth theory"

typically refers to growth of potential output, i.e., production at "full
employment," which is caused by growth in aggregate demand or
observed output.

 The growth rate of the Economy is a rate at which GDP/ Output is

increasing.

 The ultimate objective of economic activity is to provide the goods and

services that the population desires.

Employment

 Another indicator key of Economy’s health is the level of employment

 The ultimate objective of economic activity is to provide high level of

employment and low involuntary unemployment

 The unemployment rate measures the fraction of the labourforce that

is looking for but cannot find the work.

 The labour force includes all employed persons and those unemployed
individuals who are seeking jobs.

Price Stability: A situation in which prices in an economy don't change

much over time. Price stability would mean that an economy would not
experience inflation or deflation. It is not common for an economy to have
price stability.

 The third macroeconomic goal is to maintain stable prices within free

markets.
 A market economy uses prices as a yardstick to measure economic
values.

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 Rapid price changes lead to economic inefficiency

 The rate of inflation measures changes in the level of prices. It denotes
the rate of growth or decline of the price level from one year to the
next.
o An inflation occurs when the level of price is growing (the rate of
inflation is positive).
o A deflation denotes that the level of price declines (the rate of
inflation is negative).
o A disinflation is a decrease in the rate of inflation. The slowing of
the rate of inflation per unit of time.

Almost all macroeconomic events are highly interrelated. Inflation, Unemployment

and growth are related via Business cycle.

Generally, the Goals of macroeconomics are subject to:

o Interpretation - precise meanings and measurements will often

become the subject of different points of view, often caused by
politics.
o Complementary - goals that are complementary are consistent
and can often be accomplished together.
o Conflicting - where one goal precludes or is inconsistent with
another.
o Priorities - rank ordering from most important to least important;
again involving value judgments

2. MAIN MACROECONOMIC INSTRUMENTS

Macroeconomic policy instruments refer to macroeconomic quantities that can

be directly controlled by an economic policy maker.
 To achieve the above three objectives economic policy makers of countries
use mix of macroeconomics instruments.
 The most important instruments among others include monetary policy, fiscal
policy, income policy etc.
 Schools of thoughts disagree on the policy instruments they prescribe to
achieve the main economic variables. This disagreement is discussed in
detail in the section that follows.

A. MONETARY POLICY

Monetary policy is the use of interest rates, money supply and exchange rates to
influence economic growth and inflation

• Interest rates – are the cost of borrowing money

• Exchange rates – the value of one currency in terms of another
• Money supply – the amount of money in circulation in an economy

B. FISCAL POLICY

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 Fiscal policy consists in managing the national Budget and its financing
so as to influence economic activity.
 Fiscal policy is the use of government expenditures and taxes to affect
aggregate demand and aggregate supply.
 Fiscal policy looks at how government spend their money and how
they control their taxes.

C. INCOME PLOICY

 Incomes policies in economics are economy-wide wage and price

controls, most commonly instituted as a response to inflation, and
usually below market level.

1.3. SCHOOL OF THOUGHT IN MACROECONOMICS

A. CLASSICAL SCHOOL

Main Representatives of the School: Adam Smith, David Hume, D. Ricardo, J.S.
Mill, I. Fischer etc
Economic ideas:
 The dominant idea of this school of thought was the invisible hand or
lasiez fair, which means leave the market free (free market).
 The reason for their argument was that because supply will create its
own demand or price set by the private sector alone will automatically
correct/equilibrate any imbalance or disequilibria created in the
economy both in the short run and the long run without government
intervention. This law is called the “Says law”.
 Government is described as the necessary evil and hence advocated
that the government should stay away or refrain from intervening in
the market. Any government policy is ineffective to correct economic
disorder or disequilibrium. In other words, government intervention will
distort the market rather than stabilizing.
 They applied microeconomic models to the Economy-wide problems.

B. KEYNESIAN SCHOOL
Main representatives of the school: Keynes and his followers
Economic ideas:
 Emerged after the great depression of 1929-33
 Keynes believes that government should intervene in the economy to affect
total output and employment
 The ideology of classical was unable to solve this problem
 Generally, the main thesis of the Keynesian stream is that the economy is
subjected to failure so that it may not achieve full employment level. Thus,
government intervention is inevitable.

C. MONETARIST SCHOOL

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Main representatives: Friedman and his followers

Economic ideas:
 Monetarism, as advocates of free market, started challenging Keynes’s
theory in the 1970s.

 Milton Friedman, the founder of monetarism, attacked Keynes idea of

smoothing business cycle (ups and downs of the economy) on the ground
that such active policy is not only unnecessary but actually harmful,
worsening the very economic instability that it is supposed to correct, and
should be replaced by simple, mechanical monetary rules. This is the doctrine
that came to be known as “monetarism”.

 Friedman began with a factual claim: most recessions, including the huge
slump that initiated the Great Depression, did not follow Keynes’s script. That
is, they did not arise because the private sector was trying to increase its
holdings of a fixed amount of money. Rather, they occurred because of a fall
in the quantity of money in circulation.

D. NEW CLASSICAL SCHOOL

Main representatives: R. Lucas, R. Baro, T. Sergentetc

Economic Ideas:
 They are the natural successors of classical economists- also called “Fresh
Water”
 It sees the world as one in which individuals act rationally in their self-interest
in markets that adjust rapidly to changing conditions. The government, it is
claimed, is likely only to make things worse by intervening.
 The central working assumptions of the new classical school are three:
o Economic agents maximize.
o Expectations are rational.
o Markets clear.
 The essence of the new classical approach is the assumption that markets
are continuously in equilibrium.

E. NEW KEYSIAN SCHOOL

Main representatives: S. Fischer, G. Mankiw, J. Taylor, E. Phelps etc
Economic ideas:
 They are the natural successors of Keynesian economists- also called “Salt
Water”
 Market is not as perfect as classicalist suggest. Therefore, they advocate
government intervention even under rational expectation hypothesis
 According to them market failurity happens due to: asymmetry information
and Cost of changing prices.