Introduction to macroeconomics: goals, theories, models and policies
Macroeconomics studies the whole economy: output, jobs, prices and trade. Its schools of thought disagree on how far markets correct themselves.
Goals of macroeconomic policy
- Economic growth: a steady rise in real GDP, so living standards improve.
- Full employment: only frictional and structural unemployment remain (the natural rate).
- Price stability: low and stable inflation, so money keeps its value and planning is easier.
- External balance: a sustainable balance of payments and a stable exchange rate.
- Fair distribution of income and sustainable public debt.
The business (trade) cycle
- back to Expansion
Macroeconomic policy tries to smooth this cycle: cooling the economy at the peak and supporting it in a recession.
Main schools of macroeconomic thought
| School | Core belief | Role for government |
|---|---|---|
| Classical | Flexible wages and prices bring the economy back to full employment; supply creates its own demand (Say's law) | Small: balanced budgets, sound money |
| Keynesian (J. M. Keynes, 1936) | Aggregate demand can stay too low for a long time, causing lasting unemployment, as in the Great Depression of the 1930s | Active: use government spending and taxes to manage demand |
| Monetarist (Milton Friedman) | Inflation is caused mainly by too much money growth; active policy often makes things worse | Steady, predictable growth of the money supply |
| New classical and supply-side | People form rational expectations; long-run growth depends on productivity and incentives | Improve supply: education, competition, lower barriers, stable rules |
Macroeconomic models
A model is a simplified picture of the economy that keeps only the variables that matter for a question. The main models in this course are the circular flow of income, the Keynesian income-expenditure model (with the multiplier), the IS-LM model of the goods and money markets, and the AD-AS model of the price level and output. Models separate flows (measured per period, such as income and spending) from stocks (measured at a point in time, such as wealth and the money supply), and endogenous variables (explained by the model) from exogenous ones (taken as given).
Policy makers in Sri Lanka
In 2022 Sri Lanka faced a severe economic crisis, with shortages of fuel and foreign exchange, very high inflation and a suspension of external debt payments. An IMF-supported programme followed in 2023. It shows why all the macroeconomic goals are linked.
Macroeconomic conditions shape every business plan. During the 2022 crisis, Sri Lankan firms such as Cargills and John Keells had to deal with fuel shortages, import limits and rapidly rising costs at the same time. Reading CBSL and Budget announcements is part of a manager's job.
Short answer: “State four goals of macroeconomic policy.” Economic growth, full employment, price stability and a sustainable balance of payments (external balance).
Structured question: “Distinguish between the classical and Keynesian views of the economy.” Classical: flexible prices and wages restore full employment, so little government action is needed. Keynesian: demand can stay too low, causing lasting unemployment, so government should manage demand.
Essay: “Explain the main goals of macroeconomic policy and the policy tools available to achieve them, with reference to Sri Lanka.” List and explain the goals, show the business cycle, describe fiscal (Budget), monetary (CBSL) and supply-side tools, and use the 2022 crisis to show how the goals are linked.
G-E-P-B: Growth, Employment, Price stability, Balance of payments. Classical says markets fix it; Keynes says government must help.