Macroeconomics, branch of economics concerned with
the aggregate, or overall, economy. Macroeconomics deals with economic
factors such as total national output and income, unemployment, balance of
payments, and the rate of inflation. It is distinct from microeconomics, which
is the study of the composition of output such as the supply and demand for
individual goods and services, the way they are traded in markets, and the
pattern of their relative prices.
At the basis of macroeconomics is an
understanding of what constitutes national output, or national income, and the
related concept of gross national product (GNP). The GNP is the total value of
goods and services produced in an economy during a given period of time,
usually a year. The measure of what a country's economic activity produces in
the end is called final demand. The main determinants of final demand
are consumption (personal expenditure on items such as food, clothing,
appliances, and cars), investment (spending by businesses on items such as new
facilities and equipment), government spending, and net exports (exports minus
imports).
Macroeconomic theory is largely concerned with what
determines the size of GNP, its stability, and its relationship to variables
such as unemployment and inflation. The size of a country's potential GNP at
any moment in time depends on its factors of production—labor and capital—and
its technology. Over time the country's labor force, capital stock, and
technology will change, and the determination of long-run changes in a
country's productive potential is the subject matter of one branch of
macroeconomic theory known as growth theory.
The study of macroeconomics is relatively new,
generally beginning with the ideas of British economist John Maynard Keynes in
the 1930s. Keynes's ideas revolutionized thinking in several areas of macroeconomics,
including unemployment, money supply, and inflation.
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II
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KEYNESIAN THEORY AND UNEMPLOYMENT
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Unemployment causes a great deal of social distress and
concern; as a result, the causes and consequences of unemployment have received
the most attention in macroeconomic theory. Until the publication in 1936 of The
General Theory of Employment, Interest and Money by Keynes, large-scale
unemployment was generally explained in terms of rigidity in the labor market
that prevented wages from falling to a level at which the labor market would be
in equilibrium. Equilibrium would be reached when pressure from members of the
labor force seeking work had bid down the wage to the point where either some
dropped out of the labor market (the supply of labor fell) or firms became
willing to take on more labor given that the lower wage increased the
profitability of hiring more workers (demand increased). If, however, some
rigidity prevented wages from falling to the point where supply and demand for
labor were at equilibrium, then unemployment could persist. Such an obstacle
could be, for example, trade union action to maintain minimum wages or
minimum-wage legislation.
Keynes's major innovation was to argue that persistent
unemployment might be caused by a deficiency in demand for production or
services, rather than by a disequilibrium in the labor market. Such a
deficiency of demand could be explained by a failure of planned (intended)
investment to match planned (intended) savings. Savings constitute a leakage in
the circular flow by which the incomes earned in the course of producing goods
or services are transferred back into demand for other goods and services. A
leakage in the circular flow of incomes would tend to reduce the level of total
demand. “Real” investment, known as capital formation (the production of
machines, factories, housing, and so on), has the opposite effect—it is an
injection into the circular flow relating income to output—and tends to raise
the level of demand.
In the earlier classical models of unemployment,
such as the one described above, deficiency of demand in the aggregate market
for goods and services (known by the short-hand term as the goods market) was
ruled out. It was believed that any discrepancy between planned savings and
planned investment would be eliminated by changes in the rate of interest.
Thus, for example, if planned savings exceeded planned investment, the rate of
interest would fall, which would reduce the supply of savings and, at the same
time, increase the desire of companies to borrow money to invest in machines,
buildings, and so on. In other words, changes in the rate of interest would
provide the equilibrating force bringing the overall (aggregate) goods market
into equilibrium in the same way that changes in, say, the price of apples
would be the equilibrating force bringing the supply and demand for apples into
equilibrium.
In the Keynesian model, changes in the level of
output and income bring planned savings and investment into equilibrium, and
thereby lead to equilibrium in total national income and output. However, this
equilibrium level of income and output is not necessarily the level of output
at which the demand for labor equals the supply of labor. Furthermore, Keynes
maintained, a cut in wages in such a situation would not help eliminate
unemployment. Keynes was not the first economist to explain unemployment in
terms of an aggregate deficiency of demand in the goods market. The
19th-century British economist Thomas Robert Malthus and others had advanced
similar explanations.
The Keynesian revolution implied that, in the
terminology of macroeconomics, the goods market could be at an underemployment
equilibrium, in that it did not ensure equilibrium in the labor market. In such
a labor market, employers would not employ workers up to the point where it
would have been profitable for them to do so had there been adequate demand for
their output. Concepts of underemployment equilibrium, and related concepts of
constrained demand for labor were extensively developed in subsequent years.
Keynes's emphasis on demand as the key determinant
of output in the short run stimulated developments in many other fields of
macroeconomics. It was partly instrumental in the development of national
income accounting, which measures the components of GNP—consumption,
investment, government spending and net exports. The Keynesian approach also
stimulated analysis of the factors influencing these components of GNP. For
example, economists have analyzed how aggregate consumer demand is related to
income levels and how likely it is to change when rates of interest change.
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III
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MONEY SUPPLY
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Theories regarding the money supply are central to
macroeconomics. They are also the subject of debate between Keynesians and
monetarists (economists who believe that growth in the money supply is the most
important factor that determines economic growth). The classical or pre-Keynes
view was that the interest rate led to a balance between savings and
investment, which in turn would cause equilibrium in the goods market. Keynes
disagreed and believed that the interest rate was largely a monetary
phenomenon; its chief function was to balance the unpredictable supply and
demand for money, not savings and investment. This view explained why the
amount of savings was not always correlated with the amount of investment or
the interest rate.
Keynesians and monetarists also disagree about how
changes in the money supply affect employment and output. Some economists argue
that an increase in the supply of money will tend to reduce interest rates,
which in turn will stimulate investment and total demand. Therefore, an
alternative way of reducing unemployment would be to expand the money supply.
Keynesians and monetarists disagree on how successful this method of raising
output would be. Keynesians believe that under conditions of underemployment,
the increased spending will lead to greater output and employment. Monetarists,
however, generally believe that an increase in the money supply will lead to
inflation in the long run.
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IV
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INFLATION
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For several decades after World War II (1939-1945)
the main inflation theories were demand-pull and cost-push. The cost-push
theory basically emphasized the role of excessive increases in wages relative
to productivity increases as a cause of inflation, whereas the demand-pull
theory tended to attribute inflation more to excess demand in the goods market
caused by expansion of the money supply. A central concept in inflationary
theory since the mid-1950s has been the Phillips curve, which relates
the level of unemployment to the rate of inflation. The Phillips curve suggests
that society can make a choice between various combinations of inflation rate
and unemployment level. Many economists, however, dispute whether such a choice
really exists, saying that in order to keep unemployment under control it will
be necessary to accept continuously increasing inflation. At the same time many
other economists dispute whether a stable relationship between unemployment and
the level of real wage demands exists.
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V
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MODERN THEORIES
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During the last few decades there have been
numerous refinements of the Keynesian theory of unemployment. For example,
although there is still much disagreement as to the importance of wage
rigidity, significant progress has been made in explaining it without recourse
to trade union behavior or government regulation. At first it seemed difficult
to reconcile the notion of wage rigidity with the usual economist's assumption
that people seek to maximize utility or satisfaction and would be willing to
accept a lower wage in order to get a job. However, by widening the range of
variables over which individuals optimize to include variables such as loyalty
and self-respect, it has become easier to reconcile labor market disequilibrium
with the usual assumptions of optimizing behavior.
Macroeconomic theories regarding the way that the
determinants of total final demand operate form the basis of large
macroeconomic models of the economy that are used in economic forecasting to make
predictions of output and employment and related variables. During the last few
years, the record of most such predictions has been poor, and an analysis of
the errors has led to continual revisions of the basic models and refinements
of the theory.
