Chapter 4: The Macroeconomy


Macroeconomy is the economy as a whole that involves economy-wide aggregate variables like national income, unemployment, economic growth rate, etc. So, it is also known as aggregate economy.

Aggregate Demand

Aggregate Demand (AD) is defined as the total level of demand in an economy. It consists of four components:

  • Consumptions (C)
  • Investment (I)
  • Government Spending (G)
  • Net exports (X-M)

 Ad = C + I + G + (X-M)


The AD curve is downward sloping because of three effects:

  1. Real wealth effect: When price go down, purchasing power goes up and eventually consumption goes up.
  2. Interest rate effect: When price goes down, demand for money goes down which leads to fall in interest rates.
  3. International substitution effect: A rise in the price level will reduce demand for net exports.

Shift in AD

  • When real wealth increases, demand increases. AD shifts right.
  • When interest rates go down, price level goes down. AD shifts right.
  • If there is unexpected change in the price in future. AD shifts right.
  • When income from abroad increases, demand for exports increases. AD shifts right.

Aggregate Supply

Aggregate Supply (AS) is the total output that producers in an economy are willing and able to supply.


Economists sometimes distinguish between short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).

SRAS is the total output of an economy that will be supplied when there has not been enough time for the price factor of production to change.

LRAS is the total output of the country supplied in the period when the prices of the factor of production have fully adjusted.

Shifts in AS:

  • Depending on government policy, it may affect either SRAS or LRAS
  • If the prices are expected to rise, produces supply less. SRAS shifts to left.
  • Lower factor prices means lower cost of production, so SRAS shifts right and LRAS may shift right if decrease in price is permanent.
  • Lower costs of production, increases output. Both SRAS and LRAS shifts right.
  • Supply shocks increases or decreases the only SRAS is affected.

Interaction of aggregate demand and aggregate supply

The equilibrium level of output and price level are determined where aggregate demand equals to aggregate supply. The macroeconomic equilibrium is illustrated by the point where AD and AS intersects.


Inflation refers to the sustain increase in an economy’s price level and it is measured in terms of indices such as the CPI.

There are two degree of inflation:

  • Creeping inflation: It is the lower rate of inflation
  • Hyperinflation: It is an exceptionally high rate of inflation, which may result in people losing confidence in currency.

Cause of Inflation

There are two causes of inflation:

  1. Demand-pull inflation: Inflation caused by increases in aggregate demand not matched by equivalent increases in aggregate supply.
  2. Cost-push inflation: Inflation caused by increase in costs of production.

Consequences of inflation

  1. Reduction in net exports
  2. Unplanned redistribution of income
  3. Menu cost
  4. Shoe leather cost
  5. Fiscal drag
  6. Inflationary noises

Deflation and disinflation

Disinflation is the fall in inflation rate.

Deflation is a sustained fall in price level. The effect of deflation is influenced by the cause of deflation to which economist refers to good deflation and bad deflation.

The Balance of Payments

The balance of payments is the record of all the economic transactions between residents of that country and residents in another country. It is the record of country’s economic transactions with the rest of the world over the year.

The components of balance of payment

 They are:

  • Current account – record of trade in goods, trade in service, etc.
  • Capital account – record of capital transfers and acquisition and disposal of non-produced financial assets.
  • Financial account- record of transfer of financial assets between the country and the rest of the world.
  • Net errors and omissions – a figure included to ensure the balance of payments balance.

Exchange Rates

Exchange rate is the price of one currency in terms of another currency.

Trade weight exchange rate is the value of one currency against basket of currencies.

Real effective exchange rate is a currency’s value in terms of its real purchasing power.

Floating exchange rate is an exchange rate that is determined by market forces of demand and supply.

 Fixed exchange rate is an exchange rate set by the government and maintained by the central bank.

The effect of changing foreign exchange rates

They are:

  • Depreciation/ devaluation

Depreciation is a decrease in international price of a currency caused by market forces.

Devaluation is a decision by the government to lower the international price of the currency.

  • Appreciation/ revaluation

Appreciation is the increase in the international price of a currency caused by market forces.

Revaluation is a decision by government to raise the international price of its currency.


Term of trade

Term of trade is a measure of the ratio of export prices and import prices.

Absolute and comparative advantage

Absolute advantage is a situation where for a given set of resources, one country can produce more of a particular product than another country.

Comparative Advantage is a situation when a country can produce a good at a lower opportunity cost than another country.


The law of comparative advantage states that trade thus arise between two nations if there is a difference between the comparative costs of producing particular goods.


Projectionism involves protecting domestic industries from foreign competition.

It is an artificial barriers to trade.

There are many methods of protection and they are:

  1. Tariffs

 Tariffs are custom duties or taxes on imports imposed by government, serving to raise the price of imported goods. Tariffs are effective to reduce the consumption of imported goods. Imposition of tariffs helps increase domestic production.

  1. Quotas

Quotas are the limits on imports or exports. The effects of quotas are more or less similar to that of tariff but in case of quotas, they do not raise revenues for the government.

  1. Other nontariff barriers

They include embargo, voluntary export restraints, exchange controls, etc.

Benefits of Protectionism

  1. To protect infant industries
  2. To protect declining industries
  3. To protect strategic industries
  4. To prevent dumping
  5. Increasing domestic production
  6. Prevent unfair trade practices