Macroeconomics:

Scope:

Macroeconomics from the Greek prefix makro- meaning “large” and economics. It is a

branch of economics dealing with the performance, structure, behavior and decision-

making of an economy as a whole, rather than individual markets. This includes national,

regional, and global economies.

Macroeconomists study aggregated indicators such as GDP, unemployment rates, and

price indexes to understand how the whole economy functions.

Macroeconomists develop models that explain the relationship between such factors as

national income, output, consumption, unemployment, inflation, savings, investment,

international trade and international finance.

In contrast, microeconomics is primarily focused on the actions of individual agents, such

as firms and consumers and how their behavior determines prices and quantities in

specific markets.

History of Macroeconomics:

The term macroeconomics originated in the 1930s. The decade witnessed substantial

progress in the study of aggregative economic questions. One theory and set of policy

conclusions swept the field and became a new orthodoxy in macroeconomic policy

questions. The book containing this theory was The General Theory of Employment,

Interest and Money by John Maynard Keynes.

Schools of thought: Macroeconomics:

Mercantilism:

Mercantilist thought was associated with the rise of the nation-state in Europe during the

sixteenth and seventeenth century.

Two tenets of mercantilism were:

• 1. Bullionism – A belief that the wealth and power of a nation were

determined by its stock of precious metals.

• 2. The belief in the need for state action to direct the development of the

capitalist system.

Adherence to Bullionism led countries attempt to secure an excess of exports over

imports to earn gold and silver through foreign trade. Methods use to achieve this: export

subsidies, import duties, development of colonies to provide export markets. State action

was believed to be necessary to cause the developing capitalist system to further the

interests of the state.

Classical Economics:

“Classical”—written on macroeconomic issues before 1936. More conventional

terminology distinguishes between two periods in the development of economic theory

before 1930. Classical – Adam Smith (Wealth of Nations, 1776), David Ricardo (1817),

John Stuart Mill (1848). Neoclassical –Alfred Marshall (1920), A. C. Pigou (1933).

Keynes lumped these two periods together as “classical”.

Unlike the mercantilists, emphasized the importance of real factors in determining the

wealth of nations. Stressed the optimizing tendencies of the free market in the absence of

state control. Classical analysis was primarily real analysis: the growth of an economy

was the result of increase stocks of the factors of production and advances in techniques

of production.

Money only played a role in facilitating transactions as a means of exchange (money had

no intrinsic value). Most questions in economics could be answered without the role of

money. Classical economists mistrusted the government and stressed the harmony of

individual and national interests when the market was left unfettered by government

regulations, except those necessary to ensure that the market remained competitive.

In summary, two features of the classical analysis arose as part of the attack on

mercantilism:

1. Classical economics stressed the role of real as opposed to monetary factors in

Determining output and employment. Money had a role in the economy only as a

medium of exchange.

2. Classical economics stressed the self-adjusting tendencies of the economy.

Government policies to ensure an adequate demand for output were considered

unnecessary and generally harmful.

Keynesian:

Keynesian Economics developed against the background of the Great Depression of the

1930s. Unemployment in 1929 (3.2%), 1933 (25%). Keynes, a British economist, was

heavily influenced by events in his own countries than those in the US. High

unemployment in the US caused a debate, led by Keynes.

Keynes thought that high unemployment in industrialized countries was the result of a

deficiency in aggregate demand. Keynes’s theory provided the basis of economic policies

to combat unemployment by stimulating aggregate demand. Before, classical economists

recognized the human cost of unemployment but never had anything to say about the

causes of unemployment. Keynes warned that pessimistic expectations could precipitate

downward spirals in the economy.

Monetarist:

Monetarist Model developed in 1940s by Milton Friedman, Nobel Prize in Economics

1976, and University of Chicago. Argued that the Keynesian approach overstates the

amount of macroeconomic instability in the economy. Argued that most fluctuations in

real output were caused by fluctuations in the money supply, rather than by fluctuations

in consumption or investment spending.

Friedman argued that the severity of the Great Depression was caused by the Fed’s

allowing the quantity of money in the economy to fall by more than 25%. Friedman

argued that the Fed should adopt a monetary growth rule, which is a plan for increasing

the quantity of money at a fixed rate. This will reduce fluctuations in real GDP,

employment and inflation.

Friedman’s monetarist ideas attracted significant support during the 1970s and early

1980s, when the economy experience high rates of unemployment and inflation. Support

declined during late 1980s and 1990s when the unemployment and inflation rate were

relatively low.

New Classical:

Mid 1970s: Robert Lucas, Thomas Sargent, Robert Barro. Similar thinking to the

classical economists from before the Keynesian Revolution. One additional argument:

rational expectations.

Rational expectations –households (workers) and firms form expectations of the future

values of economic variables (inflation rate) by making use of all available information.

If actual inflation rate is lower than expected inflation rate, the actual real wage will be

higher than expected real wage. Higher real wages will lead to a recession because firms

will hire fewer workers and cut back on production. As workers adjust their expectations

to the lower inflation rate, real wage will decline, employment and production will

expand, bringing the economy out of recession.

Agree with monetarists: Fed should adopt a monetary growth rule. They argue that a

monetary growth rule will make it easier for workers and firms to accurately forecast the

price level, thereby reducing fluctuations in real GDP.