Course code: ED215

Module 1: Schools of Macroeconomic

Thoughts
Classical System: Say’s law and quantity
theory; Friedman’s restatement; classical
dichotomy and neutrality of money;
Keynesian vs classical system; basic tenets of
New Classical and New Keynesian System.
• What Is Macroeconomics?
• Macroeconomics is a branch of economics that
studies the behavior of an overall economy,
which encompasses markets, businesses,
consumers, and governments. Macroeconomics
examines economy-wide phenomena such as
inflation, price levels, rate of economic growth,
national income, gross domestic product (GDP),
and changes in unemployment.
• Macroeconomics is the branch of economics
that deals with the structure, performance,
behavior, and decision-making of the whole,
or aggregate, economy.
• The two main areas of macroeconomic
research are long-term economic growth and
shorter-term business cycles.
Business cycle
• In contrast to macroeconomics,
microeconomics is more focused on the
influences on and choices made by individual
actors—such as people, companies, and
industries—in the economy.
• As the term implies, macroeconomics is a field
of study that analyzes an economy through a
wide lens. This includes looking at variables
like unemployment, GDP, and inflation
• Gross domestic product (GDP) is the total
monetary or market value of all the finished
goods and services produced within a
country’s borders in a specific time period. As
a broad measure of overall domestic
production, it functions as a comprehensive
scorecard of a given country’s economic
health.
• Inflation is a rise in prices, which can be
translated as the decline of purchasing
power over time. The rate at which purchasing
power drops can be reflected in the average
price increase of a basket of selected
goods and services over some period of time.
 say's law theory
• The law is named after Jean-Baptiste Say.
Say's law, or the law of markets, is the claim
that the production of a product creates
demand for another product by providing
something of value which can be exchanged
for that other product. So, production is the
source of demand.
• Example of say's law is cash hoarding.
• According to Say's Law, the act of producing
goods and services generates income for the
producer, employees and input suppliers,
which can then be used to buy the goods that
have been produced. This process creates a
self-sustaining cycle of production, factor
incomes and consumption that then drives
economic activity.
• Say's Law suggests that there can be no
general overproduction of goods, as any
excess production will eventually be absorbed
by the increased purchasing power of the
producers. Say's Law is often associated with
classical economics and the idea of a self-
regulating market.
The Classical Quantity Theory of Money
 The Neutrality of Money and Classical
Dichotomy!
• The classical theory of output and employment is
that changes in the quantity of money affect only
nominal variables (i.e. money wages, nominal GNP,
money balances), and have no influence
whatsoever on the real variables of the economy
such as real GNP (i.e. output of goods and services
produced), level of employment (i.e. number of
labour – hours or number of workers employed),
real wage rate (i.e. wage rate in terms of its
purchasing power).
• According to classical theory, the nominal
variables move in proportion to changes in the
quantity of money, while real variables such as
GNP, employment, real wage rate, real rate of
interest remain unaffected.
• In the classical model based on flexibility of prices
and wages, changes in money supply only affect
the price level and nominal magnitudes (i.e.
money wages, nominal interest rate, while the real
variables such as levels of labour employment and
output, saving and investment, real wages, real
rate of interest remain unaffected. This
independence of real variables from changes in
money supply and nominal variables is called
classical dichotomy.
• Changes in Money Supply, Saving-Investment
Equilibrium and Neutrality of Money:
• Accord­ing to the classical theory, money
performs the function of merely a medium of
exchange of goods and services and is
therefore demanded only for transaction
purposes. This means alternative to holding
money is the purchase of goods and services.
• Therefore, demand for and supply of money in
the classical system does not determine the
rate of interest.
• When the quantity of money increases, it will
leave the real rate of interest unchanged and
hence the amount of output saved and
allocated to investment (i.e., real saving and
investment) will remain the same.
• This means the increase in money supply does
not disturb the capital market equilibrium or
saving-investment equality and consequently
the continuation of full-employment
equilibrium.
• However it may be noted that the higher level
of prices of commodities would mean that
investment expenditure in money terms will
increase in the same propor­tion as the rise in
prices even though the output of commodities
allocated for investment pur­poses remains the
same.
• Thus, with the increase in quantity of money,
the supply curve of nomi­nal saving and
investment demand curve will shift to the
right as shown by dotted S’S’ and IT curves by
the same proportion so that the same real
rate of interest is maintained and the same
amounts of real saving and investment in
terms of commodities are made at the higher
price level.
 keynesian vs classical system theory
• Classical thought believes in less government
intervention, while Keynesian thought
believes in more government intervention.
Classical thought prefers a balanced budget,
while Keynesian thought allows government
debt.
• Refer extra notes.
 Basic tenets of New Classical and New
Keynesian System
• From the new classical models it takes a
variety of modeling tools that shed light on
how households and firms make decisions
over time.
• From the new Keynesian models it takes price
rigidities and uses them to explain why
monetary policy affects employment and
production in the short run.
• Imperfect competition is another cause of
market inefficiency that New Keynesian
Economics explains.
• New Keynesian Economics argues that
unemployment is caused by the efficiency in
wages.
• The Classical Theory: is that the economy is
self‐regulating. Classical economists maintain
that the economy is always capable of
achieving the natural level of real GDP or
output, which is the level of real GDP that is
obtained when the economy's resources
are fully employed.
• While circumstances arise from time to time
that cause the economy to fall below or to
exceed the natural level of real GDP, self‐
adjustment mechanisms exist within the
market system that work to bring the
economy back to the natural level of real GDP.
• The classical doctrine—that the economy is
always at or near the natural level of real GDP
—is based on two firmly held beliefs: Say's
Law and the belief that prices, wages, and
interest rates are flexible.