Concepts of Macroeconomics (Part - 2) - Macroeconomics | Macro Economics - B Com PDF Download

Concept of Equilibrium:

Equilibrium is a concept borrowed from mechanics where we get the idea of equilibrium system of forces. In mechanics a system of forces is said to be in equilibrium if two forces making to move the body in opposite directions are counter-balanced. Thus, an equilibrium situation is a state of rest.

In economics we use the term to mean that a single price for a product is established in a market and when no economic forces are being set up to change that price. In other words, in equilibrium, the price and quantity of a commodity match both consumers’ and producers’ expectations and thus there is no discrepancy between the actual and desired prices and quantities.

Consequently, market is cleared and there are no involuntary holdings of unsold stocks. The equilibrium behaviours of consumers and producers — whether in a single market or in the economy as a whole — is characterised by the fact that there exists no feeling of urgency on the part of the buyers and sellers to change their behaviour.

In contrast, disequilibrium situation is one in which some buyers and sellers feel compelled to change their behaviour because forces are at work that change their circumstances. By changing their behaviour, however, they change the circumstances of other producers and consumers who may initially have been in equilibrium. A disequilibrium sets in motion a chain of adjustment and readjustment processes; for example, on the stock market, buyers and sellers change their behaviour daily in response to changing circumstances.

The economy as a whole would be in equilibrium when the planned demand for output is equal to planned supply of output. The whole economy would be in equilibrium when aggregate demand equals aggregate supply.

Equilibrium analyses are of two types: partial equilibrium and general equilibrium. In partial equilibrium analysis equilibrium is reached in one market assuming that all other things remain unchanged. However, in general equi­librium analysis, different markets of the economy are interdependent. In microeconomics, partial equilibrium analysis is generally used. But, in macroeconomics, general equilibrium analysis is usually used as in the classical or the Keynesian macroeconomic systems.

An equilibrium is a state of rest in which no economic forces are being generated to change the situation. In a market for a good, such a state of rest can be said to exist when there is neither excess demand for nor excess supply of the good.

An equilibrium is said to be a stable equilibrium when economic forces lend to push the market towards it, or any divergence from the equilibrium position generates forces which tend to restore the equilibrium. However, the equilibrium could be unstable when a small change in equilibrium price sends the system further and further away from equilibrium.

Production Possibility Frontier with Constant Opportunity Cost:

A production possibility frontier joins together the different combinations of goods and services which a country can produce using all available resources and the most efficient techniques of production. Let us assume that a country produces only two goods: food and cloth. Fig. 2.2 shows the different combinations of these commodities which may be produced.

The horizontal axis measures the quantity of cloth in metres and the vertical axis measures the quantity of food in tonnes. The line AB is the production possibility frontier which shows that when all resources are efficiently employed in the production of food, OA tonnes can be produced and when all resources are employed in the production of cloth. OB metre can be produced.

All points over the production possibility frontier represents combination of cloth and food which can be produced when all resources arc efficiently employed. All points inside the line, such as C. represent combinations which can be produced using less than the available resources or by using them less efficiently. Points outside the line, such as D, represent combinations which are unattainable.

The slope of the production possibility frontier (OA/OB) measures the opportunity cost in terms of food of producing extra 1 metre of cloth. Similarly, the slope (OB/OA), measures the opportunity cost in terms of cloth of producing extra 1 tonne of food. This means that every additional metre of cloth produced requires OA/OB tonnes of food be forgone and vice versa.

The slope of the production possibility curve is also known as the marginal rate of transformation. When the production possibility frontier is drawn as a straight line, the opportunity cost and the marginal rate of transformation remain unchanged no matter how much cloth is produced. This is called constant opportunity costs which is unrealistic. It means that all factors of production can be used equally efficiently in either the production of food or the production of cloth.

It is more realistic to assume that some factors are more efficient in the production of cloth and others arc more efficient in the production of food. Thus, as more and more metres of cloth are produced, it becomes necessary to move into cloth production resources which are more efficient in the production of food. This is a case of increasing opportunity costs. The case of increasing opportunity cost is represented in Fig. 2.3.

Cross-section and Time Series Data:

Economic data can be classified into cross-section and time series data. Cross-section data refer to the statistics collected from different groups of population during the same period. For example, suppose data collected on consumption expenditure of a group of families during a given year. This is a cross-section data. Similarly, if incomes of different groups are collected during a year, this will give us cross-section data. Cross-section data are useful in order to verify different functional relationships which are supposed to be invariant over time.

On the other hand, time series data is recorded with reference to time periods. The businessman is perhaps more interested in using time series data as an aid to business forecasting, particularly in areas of sales, so that in an appropriate time budget allocations may be made for investment and advertising for the year ahead. When we collect national income figures of a country for different years it represents time series data.

If we are to plot a time series data in a graph we plot time (t) on the horizontal axis and the value of the variable on the vertical axis. Time series data are necessary when we are interested in the analysis of seasonal or cyclical variations.

Cross-section data are more useful in order to verify functional relationships which are supposed to be invariant over time. Both types of data are useful in the study of macro­economics. For example, consumption function hypothesis may be tested either with reference to cross-section or time-series data.

Aggregate Demand and Supply:

The key concepts in macroeconomics are aggregate demand and aggregate supply. Here we provide a brief preview of these concepts and their interaction. The level of output and the price level are determined by the interaction of aggregate demand and aggregate supply. Under some conditions, employment depends only on total spending or aggregate demand. At other time, supply limitations are an important part of the policy problem and have to receive important attention.

From 1930s to the 1960s macroeconomics was very much demand determined. But in recent years the emphasis has been shifted, and aggregate supply and supply side economics have gained in importance. This shift of emphasis and interest are fostered by the slow growth and high inflation experienced in the 1970s.

What are the relationships between aggregate demand and supply, output and employment, and prices? Aggregate demand is the relationship between spending on commodities and the level of prices. When unemployment is high, increased spending — or an increase in aggregate demand — will raise output and employment with little effect on prices. For example, during the Great Depression of the 1930s, it would certainly be appropriate to use expansionary aggregate demand policies.

But if the economy is close to full employment, increased aggregate demand will be inflationary. The aggregate supply side of the economy has to be introduced. The aggregate supply curve specifies the relationship between the amount of output firms produce and the price level.

The supply side not only tells us how successful demand expansions will be in raising output and employment, but it also has a role of its own. Supply shocks can reduce output and raise prices, as was the case in the 1970s when the price of oil increased sharply. Conversely, policies that increase productivity — and hence aggregate supply — can help reduce inflationary pressure.

The Unemployment Rate:

One aspect of economic performance is how well an economy uses its resources. Since an economy’s workers are its chief resource, keeping workers employed is a concern of policy-makers. The unemployment rate is the statistic that measures the percentage of those people who want to work but could not find any job.

Unfortunately, unemployment has been a recurring feature of Western capitalist economy and its eradication has become one of the major policy objectives.

The labour force is defined as the sum of the employed and unemployed, and the unemployment rate is defined as the percentage of the labour force unemployed.

Labour Force = Number of Employed + Number of Unemployed.

Unemployment Rate = Number of Workers Unemployed x 100/ Total Labour Force

A related statistic is the labour-force participation rate, the percentage of the adult population in the labour force:

Labour-Force Participation Rate = Labour Force x 100/Adult Population

Natural Unemployment:

Natural unemployment is defined as that which exists even when the overall demand for labour is equal to its supply at the prevailing level of real wages. Or, it is that unemployment which exists when the labour market is in equilibrium. Such unemployment persists because of frictions in the economy which prevent some workers from taking up the available jobs. Natural unemployment may be illustrated in Fig. 2.4 where DD_L is the demand curve for labour and SS_L is the supply curve of labour.

The curve EE shows the actual number employed at different wage rates and, because of frictions in the economy, actual employment always falls short of the demand for and supply of labour. At the real wage rate OW₁, the demand and supply of labour are just equal at OL but actual employment is only OA, thus At is the ‘natural’ unemployment.