Chapter one

The State of Macroeconomics – Introduction

Macroeconomics is concerned with the behavior of the economy as a whole-
with booms and recessions, the economy's total output of goods and services and
the growth of output, the rates of inflation and unemployment, the balance of
payments and the exchange rates.

The difference between microeconomics and macroeconomics is primarily one

of emphasis and exposition. In studying price determination in a single industry,
it is convenient for microeconomics to assume that prices in other industries are
given. In macroeconomics, in which we study the average price level, it is for the
most part sensible to ignore changes in relative prices of goods among different
industries. In microeconomics, it is convenient to assume that the total income
of all consumers is given and then to ask how consumers divide their spending of
that income among different goods. In macroeconomics, by contrast, the
aggregate level of income or spending is among the key variables to be studied.

The most helpful circumstance for the rapid propagation of a new revolutionary
theory is the existence of an established orthodoxy, which is clearly inconsistent
with the most salient facts of reality. The inability of the classical model to
account adequately for the collapse of output and employment in the 1930s paved
the way for the Keynesian revolution. During the1950s and 1960s, the
neoclassical synthesis became the accepted wisdom for the majority of
economists.

In this unit, we will first define macroeconomics and then briefly explain the
focus areas and objectives of macroeconomics. Later in the chapter, the major
schools of thoughts in macroeconomics are presented in detail.
 SECTION ONE: DEFINITION AND FOCUS AREAS OF
MACROECONOMICS

1.1 Definition of Macroeconomics

Macroeconomics is concerned with the structure, performance and behavior of the
economy as a whole. It explains the overall level of a nation’s output,
employment, prices, and foreign trade. The prime concern of macroeconomists is
to analyze and attempt to understand the underlying determinants of the main
aggregate trends in the economy with respect to the total output of goods and
services (GDP), unemployment, inflation and international transactions. In
particular, macroeconomic analysis seeks to explain the cause and impact of
short-run fluctuations in GDP (the business cycle), and the major determinants of
the long-run path of GDP (economic growth). Obviously the subject matter of
macroeconomics is of crucial importance because in one way or another
macroeconomic events have an important influence on the lives and welfare of all
of us.
1.2 Focus areas of Macroeconomics
Macroeconomics focuses on the economic behavior and policies that affect
consumption and investment, trade balance, the determinants of changes in wages
and prices, monetary and fiscal policies, the money stock, the federal budget, the
interest rates and the national debt.

In brief, macroeconomics deals with the major economic issues and problems of
the day. To understand these issues, we have to reduce the complicated details of
the economy to manageable essentials. Those essentials lay in the interactions
among the goods, labor and asset markets of the economy, and in the interactions
among the national economies whose residents trade with each other.

In macroeconomics we deal with the market for goods as a whole, treating all the
markets for different goods as a single market. Similarly, we deal with the labor
market and the asset market as a whole.
 The benefit of abstracting is increased understanding of the vital interactions
among the goods, labor, and assets markets. The cost of abstraction is that omitted
details sometimes matter.

It is difficult to overstate just how important satisfactory macroeconomic

performance is for the well-being of the citizens of any country. An economy that
has successful macroeconomic management should experience low
unemployment and inflation, and steady and sustained economic growth. In
contrast, in a country where there is macroeconomic mismanagement, we will
observe an adverse impact on the living standards and employment opportunities
of the citizens of that country. In extreme circumstances, the consequences of
macroeconomic instability have been devastating. For example, the catastrophic
political and economic consequences of failing to maintain macroeconomic
stability among the major industrial nations during the period 1918-33 ignited a
chain of events that contributed to the outbreak of the Second World War, with
disastrous consequences for both humanity and the world economy
.Macroeconomics deals with such major issues “Economic growth, Inflation,
Unemployment, Foreign trade Based on those problems the objectives of
macroeconomics are:
 Generating a high level of production of economic goods and services for the
population.
 High employment - providing jobs
 A stable or gently rising level of price level with prices and wages are determined
by free markets.
 Foreign economic relations marked by a stable foreign exchange rate and exports
more or less balancing imports

SECTION TWO: THE STATE OF MACROECONOMICS

2.1 Evolution and Recent Developments

The Great Depression gave birth to modern macroeconomics as surely as

accelerating inflation in the late 1960s and early 1970s facilitated the monetarist
counter-revolution.
It is also important to note that many of the most famous economists of the
twentieth century, such as Milton Friedman, James Tobin and Paul Samuelson,
were inspired to study economics in the first place as a direct result of their
personal experiences during this period.
While Laidler has reminded us that there is an extensive literature analyzing the
causes and consequences of economic fluctuations and monetary instability prior
to the 1930s, the story of modern macroeconomics undoubtedly begins with the
Great Depression. Before 1936, macroeconomics consisted of an 'intellectual
witch's brew: many ingredients, some of them exotic, many insights, but also a
great deal of confusion. For more than 70 years, economists have attempted to
provide a coherent explanation of how the world economy suffered such a
catastrophe.
Although it is important to remember that economists before Keynes discussed
what we now call macroeconomic issues such as business cycles, inflation,
unemployment and growth, as we have already noted, the birth of modern
macroeconomics as a coherent and systematic approach to aggregate economic
phenomena can be traced back to the publication in February 1936 of Keynes's
book The General Theory of Employment, Interest and Money.

2.2 The Classical and Neoclassical Macroeconomics School

Classical economics is that body of thought, which existed prior to the publication
of Keynes's, General Theory. For Keynes the classical school not only included
Adam Smith, David Ricardo and John Stuart Mill, but also 'the followers of
Ricardo. Keynes was therefore at odds with the conventional history of economic
thought classification, particularly with his inclusion of both Alfred Marshall and
Arthur Cecil Pigou within the classical school. However, given that most of the
theoretical advances, which distinguish the neoclassical from the classical period,
had been in microeconomic analysis, Keynes perhaps felt justified in regarding
the macroeconomic ideas of the 1776-1936 period, such as they existed, as being
reasonably homogeneous in terms of their broad message.
 This placed great faith in the natural market adjustment mechanisms as a means
of maintaining full employment equilibrium.

Before moving on to examine the main strands of macroeconomic thought

associated with the classical economists, the reader should be aware that, prior to
the publication of the General Theory, there was no single unified or formalized
theory of aggregate employment, and substantial differences existed between
economists on the nature and origin of the business cycle .The structure of
classical macroeconomics mainly emerge after 1936 and did so largely in
response to Keynes's own theory in order that comparisons could be made.
Classical economists were well aware that a capitalist market economy could
deviate from its equilibrium level of output and employment. However, they
believed that such disturbances would be temporary and very short-lived. Their
collective view was that the market mechanism would operate relatively quickly
and efficiently to restore full employment equilibrium. If the classical economic
analysis was correct, then government intervention, in the form of activist
stabilization policies, would be neither necessary nor desirable. Indeed, such
policies were more than likely to create greater instability. It follows that the
classical writers gave little attention to either the factors, which determine
aggregate demand, or the policies, which could be used to stabilize aggregate
demand in order to promote full employment. For the classical economists full
employment was the normal state of affairs. But how did the classical economists
reach such an optimistic conclusion? In what follows we will present a 'stylized'
version of the classical model which seeks to explain the determinants of an
economy's level of real output ( Y), real wage (W/P) and nominal (W) wages, the
price level (P) and the real rate of interest (r) In this stylized model it is assumed
that:
 All economic agents (firms and households) are rational and aim to maximize
their profits or utility; furthermore, they do not suffer from money illusion;
 All markets are perfectly competitive, so that agents decide how much to buy and
sell based on a given set of prices, which are perfectly flexible;
 All agents have perfect knowledge of market conditions and prices before
 engaging in trade
 Trade only takes place when market-clearing prices have been established in all
markets, agents have stable expectations.
These assumptions ensure that in the classical model, markets, including the labor
market, always clear.
2.3 The Keynesian Macroeconomics School
For the early post-war years, the central distinguishing beliefs within the orthodox
Keynesian school can be listed as follows:
 The economy is inherently unstable and is subject to erratic shocks. These shocks
are attributed primarily to changes in the marginal efficiency of investment
following a change in the state of business confidence, or what Keynes referred to
as a change in investors' 'animal spirits'.
 Left to its own devices the economy can take a long time to return to the
neighborhood of full employment after being subjected to some disturbance; that
is, the economy is not rapidly self-equilibrating.
 The aggregate level of output and employment is essentially determined by
aggregate demand and the authorities can intervene to influence the level of
aggregate 'effective' demand to ensure a more rapid return to full employment.
 In the conduct of stabilization policy, fiscal as opposed to monetary policy is
generally preferred as the effects of fiscal policy measures are considered to be
more direct, predictable and faster acting on aggregate demand than those of
monetary policy. These beliefs found expression in the orthodox Keynesian
model, known as the IS-LM model.
 In the General Theory Keynes sets out to 'discover what determines at any time
the national income of a given system and the amount of its employment. In the
framework he constructs, the national income depends on the volume of
employment.
 In developing his theory, Keynes also attempted to show that macroeconomic
equilibrium is consistent with involuntary unemployment. The theoretical novelty
and central proposition of the book is the principle of effective demand, together
with the equilibrating role of changes in output rather than prices. The emphasis
given to quantity rather than price adjustment in the general Theory is in sharp
contrast to the classical model, where discrepancies between saving and
investment decisions cause the price level to oscillate.

2.4 The New Classical Macroeconomics School

During the early 1970s, there was a significant renaissance of the belief that a
market economy is capable of achieving macroeconomic stability, providing that
the visible hand of government is prevented from conducting misguided
discretionary fiscal and monetary policies. In particular the 'Great Inflation' of the
1970s provided increasing credibility and influence to those economists who had
warned that Keynesian activism was both over ambitious and, more importantly,
predicated on theories that were fundamentally flawed.
To the Keynesian critics the events of the Great Depression together with
Keynes's theoretical contribution had mistakenly left the world 'deeply skeptical
about self-organizing market systems.' The orthodox Keynesian insistence that
relatively low levels of unemployment are achievable via the use of expansionary
aggregate demand policies was vigorously challenged by Milton Friedman, who
launched a monetarist 'counter-revolution' against policy activism during the
1950s and 1960s. During the 1970s, another group of economists provided a
much more damaging critique of Keynesian economics. Their main argument
against Keynes and the Keynesians was that they had failed to explore the full
implications of endogenously formed expectations on the behavior of economic
agents. Moreover, these critics insisted that the only acceptable way to
incorporate expectations into macroeconomic models was to adopt some variant
of John Muth's (1961) 'rational expectations hypothesis.' Following Thomas
Sargent's (1979) contribution, rational expectationists, who also adhered to the
principle of equilibrium theorizing, became known collectively as the new
classical school. As the label infers, the new classical school has sought to restore
classical modes of equilibrium analysis by assuming continuous market clearing
within a framework of competitive markets.
The assumption of market clearing, which implies perfectly and instantaneously
flexible prices, represents the most controversial aspect of new classical
theorizing. The incorporation of this assumption represents the classical element
in their thinking, namely a firm conviction 'that the economy should be modeled
as an economic equilibrium'. Thus, to new classical theorists, 'the ultimate
macroeconomics is a fully specified general equilibrium microeconomics.' This
approach implies not only the revival of classical modes of thought but also 'the
euthanasia of macroeconomics.'
This school of macroeconomics, which includes among its leaders Robert Lucas,
Thomas Sargent, Robert Barro, and Edward Prescott and Neil Wallace of the
University of Minnesota, shares many policy views with Freidman. 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. Their approach is a challenge to
traditional macroeconomics, which sees a role for useful government action in an
economy that is viewed as adjusting sluggishly, with slowly responding prices,
poor information, and social customs impeding the rapid clearing of markets.
The central working assumptions of the new classical school are three:
1. Economic agents maximize. Households and firms make optimal decisions.
This means that they use all available information in reaching decisions and that
those decisions are the best possible in the circumstances in which they find
themselves.
2. Expectations are rational, which means they are statistically the best predictions
of the future that can be made using the available information. indeed, the new
classical school is sometimes described as the rational expectations school, even
though rational expectations is the only one part of the theoretical approach of the
new classical economists. Rational expectations imply that people will eventually
come to understand whatever government policy is being used, and thus that it is
not possible to fool most of the people all the time or even most of the time.
3. Markets clear. There is no reason why firms or workers would not adjust wages
and prices if that would make them better off. Accordingly, prices and wages
adjust in order to equate supply and demand; in other words, markets clear.
One dramatic implication of these assumptions, which seem so reasonable
individually, is that there is no possibility for involuntary unemployment. Any
unemployed person who really wants a job will offer to cut his or her wage until
the wage is low enough to attract an offer from some employer. Similarly, anyone
with an excess supply of goods on the shelf will cut prices so as to sell. Flexible
adjustment of wages and prices leaves all individuals all the time in a situation in
which they work as much as they want and firms produce as much as they want.
The essence of the new classical approach is the assumption that markets are
continuously in equilibrium. In particular, new classical macroeconomics regard
as incomplete or unsatisfactory any theory that leaves open the possibility that
private individuals could make themselves better off by trading among
themselves.

2.5 The New Keynesian Macroeconomics School

During the 1980s, there was a growth of interest in the early Keynes in order to
better understand the later Keynes of the General Theory. There is an increasing
recognition and acceptance that Keynes's philosophical and methodological
framework had a significant influence upon his economic analysis as well as his
politics. Whilst much has been written about the alleged content of Keynes's
economics, very little has dealt with Keynes's method and philosophy. The great
stimulus to macroeconomic theory provided by Keynes is well recognized but
much less is said about his views on scientific methodology, 'Keynes's
methodological contribution has been neglected generally. The only major
exception to the change was the latter's earlier study, which endeavored to provide
a serious extended analysis of the connection between Keynes's philosophy and
his economics. The more recent attempts to explore the methodological and
philosophical foundations of Keynes's political economy have been termed 'the
new Keynes scholarship.' The main aim of the new scholarship is to highlight the
need to recognize that Keynes's economics has a strong philosophical base and to
provide a detailed examination of Keynes's rich and elaborate treatment of
uncertainty, knowledge, ignorance and probability.
The new scholarship also gives prime importance to Keynes's lifelong fascination
with the problem of decision making under conditions of uncertainty.
The new classical school group remains highly influential in today's
macroeconomics. But a new generation of scholars, the new Keynesians, mostly
trained in the Keynesian tradition but moving beyond it, emerged in the 1980s.
the group includes among others George Akerlof and Janet Yallen and David
Romer of the University of California- Berkeley, Olivier Blanchard of MIT, Greg
Mankiw and Larry Summers of Harvard, and Ben Bernanke of Princeton
university. They do not believe that markets clear all the time but seek to
understand and explain exactly why markets can fail.
The new Keynesian argues that markets sometimes do not clear even when
individuals are looking out for their own interests. Both information problem and
costs of changing prices lead to some price rigidities, which help cause
macroeconomic fluctuations in output and employment. For example, in the labor
market, firms that cut wage not only reduce the cost of labor but also are also
likely to wind up with a poorer quality labor force. Thus, they will be reluctant to
cut wages. If it is costly for firms to change the prices they charge and the wages,
they pay, the changes will be infrequent; but if all firms adjust prices and wages
infrequently, the economy wide level of wages and prices may not be flexible
enough to avoid occasional periods of even high unemployment.