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INTRODUCTION TO MACROECONOMICS:Price Level and its Effects:

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Introduction to Economics ­ECO401
VU
UNIT - 8
Lesson 8.1
INTRODUCTION TO MACROECONOMICS
As a subject, macroeconomics only began to be taught in colleges and universities in the 1940s
after the influence of a very influential British economist, John Maynard Keynes who believed the
macro economy (with its associated variables) deserved to be understood and analyzed in its
own right, and not just as an aggregation of the various micro-markets, as was believed earlier.
Macroeconomics deals with the behaviour of the economy as a whole. The variables of interest
change from the price, demand or supply of a particular product to the economy-wide price level,
aggregate demand and aggregate supply.
Aggregate Demand (AD):
Aggregate demand (AD) is the total planned or desired spending (expenditure) in the economy
during a given period. AD is the sum of consumption, investment, government spending and net
exports (i.e. exports minus imports), and is inversely related to the aggregate price level through
the wealth, interest rate and international purchasing power effects.
Price Level and its Effects:
The price level is the weighted average price index of the prices of all the goods and services in
the economy.
Inflation or inflation rate is the percentage annual increase in the price level.
Hyperinflation is inflation at extremely high rates (say 1000, 1 million, or even 1 billion percent a
year).
The wealth effect of a price level increase on AD is negative and works through the reduction in
the purchasing power of consumers' income and wealth (real asset values). These cause a
reduction in consumption demand.
The interest rate effect of a price level increase on AD is negative as it causes a fall in
investment demand. Higher prices cause the nominal interest rate to rise discouraging firm
investment.
The international purchasing power (or competitiveness) effect of a price level increase on AD is
also negative as it reduces the net foreign demand for domestic goods and services. As the
price level of a certain country increases the demand for its exports falls because they become
expensive (less competitive) in international markets.
Shifts in Aggregate Demand:
AD shifts to the right when any component of AD increases autonomously; e.g., if a) consumers
become more willing to spend at every price level; b) there are autonomous increases in
investment due to better business prospects; c) the government spends more, or reduces taxes;
net exports rise at all prices (due to say an increase in the quality of domestic goods relative to
foreign goods).
Aggregate Supply (AS):
Aggregate supply (AS) is the total value of goods and services that all the firms in the economy
would and can willingly produce in a given time period. Aggregate supply is a function of
available inputs, technology and the price level. It slopes upward in P-Output space but the
exact slope depends whether the economy is operating at below full employment (flat) or full
employment (steep)
Full Employment:
Full employment is a state of the economy in which the productive resources of the economy are
fully employed. Output may be expanded from this full employment level by asking labourers to
work overtime or renting capital from outside. An alternative (historical) definition of full
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Introduction to Economics ­ECO401
VU
employment was: that level of employment at which no (or minimal) involuntary unemployment
exists.
The Concept of Invisible Hand:
Invisible hand was a concept introduced by Adam Smith in 1776 to describe the paradox of
laissez-faire market economy. The invisible hand doctrine holds that, with each participant
pursuing his or her own private interest, a market system nevertheless works to the benefits of
all as though a benevolent invisible hand were directing the whole process.
Classical Economists:
Classical economists were the earliest brand of economists the world knew. They were
essentially micro-economists who believed the macro economy was an uninteresting
aggregation of individual (or micro) markets, and any problem at the macro level was necessarily
a symptom of some micro level problem.
The optimal role for the government under Classical economics was one of laissez-faire. They
believed that if the prices of goods, services and factors were allowed to be determined by the
free operation of the forces of demand and supply (i.e. the price mechanism) the best possible
outcome for resource allocation would obtain. In other words the economy would be at the full
employment level, and it would not be possible to improve that situation through government
intervention.
A recession is a downturn in real GDP for two or more successive quarters.
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Table of Contents:
  1. INTRODUCTION TO ECONOMICS:Economic Systems
  2. INTRODUCTION TO ECONOMICS (CONTINUED………):Opportunity Cost
  3. DEMAND, SUPPLY AND EQUILIBRIUM:Goods Market and Factors Market
  4. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..)
  5. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..):Equilibrium
  6. ELASTICITIES:Price Elasticity of Demand, Point Elasticity, Arc Elasticity
  7. ELASTICITIES (CONTINUED………….):Total revenue and Elasticity
  8. ELASTICITIES (CONTINUED………….):Short Run and Long Run, Incidence of Taxation
  9. BACKGROUND TO DEMAND/CONSUMPTION:CONSUMER BEHAVIOR
  10. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)
  11. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)The Indifference Curve Approach
  12. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….):Normal Goods and Giffen Good
  13. BACKGROUND TO SUPPLY/COSTS:PRODUCTIVE THEORY
  14. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):The Scale of Production
  15. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):Isoquant
  16. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):COSTS
  17. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):REVENUES
  18. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):PROFIT MAXIMISATION
  19. MARKET STRUCTURES:PERFECT COMPETITION, Allocative efficiency
  20. MARKET STRUCTURES (CONTINUED………..):MONOPOLY
  21. MARKET STRUCTURES (CONTINUED………..):PRICE DISCRIMINATION
  22. MARKET STRUCTURES (CONTINUED………..):OLIGOPOLY
  23. SELECTED ISSUES IN MICROECONOMICS:WELFARE ECONOMICS
  24. SELECTED ISSUES IN MICROECONOMICS (CONTINUED……………)
  25. INTRODUCTION TO MACROECONOMICS:Price Level and its Effects:
  26. INTRODUCTION TO MACROECONOMICS (CONTINUED………..)
  27. INTRODUCTION TO MACROECONOMICS (CONTINUED………..):The Monetarist School
  28. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME
  29. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME (CONTINUED……………..)
  30. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME
  31. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..)
  32. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..):The Accelerator
  33. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS
  34. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….)
  35. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Causes of Inflation
  36. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):BALANCE OF PAYMENTS
  37. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):GROWTH
  38. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Land
  39. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Growth-inflation
  40. FISCAL POLICY AND TAXATION:Budget Deficit, Budget Surplus and Balanced Budget
  41. MONEY, CENTRAL BANKING AND MONETARY POLICY
  42. MONEY, CENTRAL BANKING AND MONETARY POLICY (CONTINUED…….)
  43. JOINT EQUILIBRIUM IN THE MONEY AND GOODS MARKETS: THE IS-LM FRAMEWORK
  44. AN INTRODUCTION TO INTERNATIONAL TRADE AND FINANCE
  45. PROBLEMS OF LOWER INCOME COUNTRIES:Poverty trap theories: